Interest rates have been at record lows for over 9 years, causing problems for income investors, who have had to take on more risk to get some decent income yields. So what can income investors do to maximise their income potential going forward, without risking too much capital?
The good news is that the situation may be easing, as there are signs that interest rates may start to move up, possibly in the UK as well as the US.
That may be encouraging news. However, the starting point for income investors is not to look at income investing in isolation but to take a holistic approach, seeing it as part of your overall financial situation and personal circumstances. You need to be clear about what you want to achieve, how much income you need and how much risk you’re willing to take to get it.
Look at funds
You may get the best long-term returns by investing in shares, some of which pay very good dividends. However, this is a relatively high risk strategy, so it might make more sense to put some or all of your money in investment funds, as it spreads the risk and you should get a return of between 3-4%.
You should also look to diversify your investments across asset classes. This diversification allows you to buy into higher-paying assets, but ensures that not all your capital is tied up in riskier investments.
So alongside equities and equity based funds, you should look at other asset classes such as fixed interest - corporate and government bonds - and commercial property. Other options could include cash and infrastructure. A multi-asset investment approach with an income focus could be a good way forward.
The amount you actually invest in the different asset classes should depend on your circumstances, objectives and attitude to risk. For example, having 50% in equities, 35% per cent in fixed interest and 15% in property would be a reasonable mix for some.
When it comes to looking for dividends, traditionally the UK market has been the place to be, with a plethora of good, solid equity income funds. However, whilst these are still performing reasonably well, more overseas companies are now focused on using profits to make dividend payments to investors. This has created more options for income investors and some sectors in particular have performed extremely well.
By investing in a mix of UK and global funds, you can help to further diversify your holdings.
Another way to reduce risk as you seek income is to 'drip feed' money into markets on a regular basis rather than risk investing a lump sum at what might turn out to be a bad time. This counter-balances the risk of market timing and stops you investing everything just as the market peaks.
Some people opt to take a regular fixed income from their portfolio. This can be fine but it can lead to capital losses when markets fall, leading to a long-term reduction in income as well.
The simple way, if you don’t rely on a regular income, is just to take the ‘natural yield’ from your investments, taking dividend payments as and when they are paid out.
However, if you do need a regular fixed income, in a prolonged downturn, you should also be prepared to reduce the income you take to help preserve your capital.
If not, you may be forced into taking a larger slice of your remaining funds to meet your future income needs, further depleting your portfolio.
Don’t forget capital growth
For this reason, whilst you are investing for income, you should not totally ignore capital growth, particularly if you want your investments to provide a sustainable income for 20-30 years.
If you focus solely on investments that pay the highest yields, this could potentially put your capital at risk. In turn, this could affect the income you receive long-term. Try to balance income needs with growth options.
Where possible too, you should look to reinvest any income payments that are surplus to your immediate requirements, to boost your overall returns going forward. The power of compound interest is a wonderful thing and over time reinvesting dividends should help grow your capital, delivering a more sustainable long-term income stream.
Review your investments regularly
Finally, and particularly in these somewhat uncertain times, you should look to review your investments on a regular basis. You should be asking whether your investment portfolio has generated the income you expected and if it has underperformed, you may want to consider rebalancing your portfolio.
For help and advice on your income investing plans, please contact Kellands.