Five tips for investors beginning their income journey
It’s important to remember that income matters more when you’re investing for the long term. The best result is a mix of capital growth and higher-than-expected income.
7 April 2016
With pension freedoms allowing savers to access their entire retirement fund, smart investors are looking at the best ways to generate income, and one of the first things they will look at when considering an investment is its dividend yield.
The headline yield, which is a measure of the income an investment generates, is often the focus of investors. While this is an important consideration for those seeking an income, savvy investors will consider the headline number as only the beginning of what we might call an income journey. Here’s what we mean.
1. Look for a reasonable headline dividend yield
The headline figure is of course an important one. If you invest £100, the difference between getting paid an income of £1 or £10 from that investment in a year’s time is a big one.
2. Examine the underlying capital
Let’s say that your original £100 investment – the capital – is invested in the shares of UK companies. The value of those shares can fall as well as rise, depending on the performance of that company. There is, of course, the risk you may not get back the money you originally put in.
3. Consider how these work together
Once you have invested that money, instead of worrying about its headline. yield, you would do better to focus on the actual income being generated and how this is affecting your investment. This is because yield is not a standalone figure, but a ratio made up of income and capital. What that means is your yield can increase in two ways – one good and one bad. Yield will increase if your original investment generates more income, or it will increase if your original investment shrinks. Clearly the latter outcome is one you would rather avoid. Anybody who focuses on yield as a single number is going to miss this nuanced but important difference.
4. Put it all into practice
To illustrate our point, let’s say you invest £100 in a fund in the expectation of receiving £5 in income after one year. If the price remains the same, this would give you a yield of 5pc. Let’s look at what would happen if you received income of £5 as expected, but your investment halved in value. Here, the yield would double to 10pc (five as a percentage of 50) but in all likelihood you would be very unhappy. Now let’s look at what would happen if your original investment doubles in value. Your headline figure would have halved to 2.5pc (five as a percentage of 200) but you’ve had an outstanding result, with more income and capital. This is an extreme example, but it demonstrates the point that the best result is a combination of capital growth and higher-than-expected income.
5. Do your research
We would argue very strongly that yield should only matter to investors on the day they embark on their income journey. After that, unless you are planning to spend your capital any time soon – in which case you really need to question if you should be investing in shares at all – yield is too simplistic and thus all but irrelevant. Instead, your focus should be a separate understanding of your income – ideally a growing income – and what is happening to your capital. There are a number of funds for those seeking an income, and each will operate in a slightly different way. It’s a good idea to understand how they work, the level of risk you’re willing to take, and the approach individual managers take, before handing over your hard-earned money.
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