According to the myths of investing, as an investor you will either be seeking to grow your wealth or seeking extra income. In practice, many investors want a mix of both.
Indeed, if your portfolio does not increase at least in line with inflation in real terms, you will grow poorer over time. Most income-seekers recognise this and you can argue that a balanced income portfolio therefore has to contain some growth potential to cover inflation at the minimum.
Income: The tortoise not the hare?
Investors with income as their focus may often think of themselves as the tortoise rather than the hare when it comes to the investment race. For an income seeker to invest in shares, companies need to pay a dividend. Generally, new start-ups and, hence, higher-risk growth companies do not pay dividends until their business model has been proven. Consequently, they are not seen as a natural investment for income-seeking investors.
But how do you keep up with inflation if you take all the value out via the dividend and there is no overall portfolio growth? You will literally grow poorer with time if the dividends you receive do not beat inflation.
It’s time to consider other reptiles that can run faster than the traditional tortoise.
Lizards in the cold don’t move, but when the sun comes out…
Investors who have a balanced portfolio of solid dividend-paying tortoises, such as the banks and utility sectors, could also aim for increased value and dividends through buying into larger companies that are out of favour. Typically, the lizards laze around lethargically while their businesses are out of favour, but as soon as the sun comes out and business picks up, they become surprisingly fast-moving.
Watch out also for negative sector sentiment, which can sometimes drag a good business down. Picking up shares in companies that may be unfashionable but that have a long track record and holding them, until either the business cycle comes around or new management takes effect, can give investors a hedge. The share price can recover and dividends can resume or increase or, in the best-case scenario, do both.
Any capital gain could then be taken and the portfolio diversified by buying another holding. This can achieve the income aim while also growing the portfolio value, adding the potential for increasing income and thereby beating inflation.
You could also seek companies that are profitable and buying back their own shares – this is quite in vogue at the moment. The underlying benefit to buying companies like this is that, theoretically, with fewer shares on the market, this increases the proportion of shares a company owns, hence increasing the value of shares still available.
Balance by diversifying
Investing in income-producing stocks takes planning and, like achieving a neat garden, requires regular trimming and weeding. Buying into a dozen companies will protect you from suffering one major loss through diversifying your risk, particularly if you buy in different sectors.
To run any balanced portfolio, you must be prepared to take profits and losses, do your research and diversify your risk. These are the same basic investing skills needed when seeking high-capital growth, but the difference is in the aim.
A balanced portfolio aiming for income will most likely have a number of different products and sectors. These range from National Savings Certificates, corporate bond funds, income-bearing investment trusts, gilts, individual equities, iShares (exchange traded funds), tracker funds and real estate investment trusts (REITs, recently introduced by the Government). These potentially allow a wide range of portfolio risk, from government debt, company debt and diversified equity trackers through to exposure to property income.
ISA: An income seeker’s best friend
Having built a balanced income portfolio, the dividend cheques are now rolling in. However, the only blot on this horizon is that all that income could be taxed and, if you are a higher-rate taxpayer, you will need to pay even more in your tax return. This could mean the difference between a dividend paying more than inflation or being less than inflation, after tax.
But don’t forget that an ISA does not attract tax above the basic rate of 10% on dividends, saving a basic-rate taxpayer 10% in tax on dividends and higher-rate taxpayers even more. Holding shares in an ISA is the smart way to maximise returns and minimise the tax paid.
Also, higher-rate taxpayers do not have to declare income from an ISA, saving on paperwork. If you are near the top of the 22% tax bracket, and a dividend takes you into the 40% bracket, by using an ISA the income will not get added and you will avoid moving into the next tax level.
We like tortoises and hares alike
Hoodless Brennan is one of the leading brokers in the small cap investment market – typically known as hares. However, we also offer a full advisory service to help you in your investment strategy, covering all sectors and investment aims.
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