The term Income Shares has its origins in the classification of dual-fund investments between capital appreciation and distributions.
The shares bought for capital appreciation (growth shares) are sometimes managed by a fund manager or owned by an individual to make a profit when the shares are later sold. That can be over a short or medium investment period.
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Whereas the shares classified under income were held for the long term to provide a regular source of dividend payments for distribution to the holders.
Taxation legislation has largely eliminated dual funds, with dividend income housed separately from capital gains. The moniker of income shares now refers to standalone stocks renowned for their dependable dividends.
As wealth has increased worldwide, many investors now look for securities that can provide a regular source of income in retirement. The tools and information now at their disposal make this a more straightforward process, but there are some pitfalls.
This article will examine what to consider when choosing good income shares and some of the pitfalls investors may encounter as they build a portfolio for retirement.
When considering buying income shares, the primary concern is researching the current dividend and the expected yield from owning those shares. However, several factors must be considered when deciding which shares will produce the best dividend yield.
The factors can be examined in various stages, taking into consideration share allocation, risk management and how to improve outcomes:
Table of contents
Allocating funds
The potential return on shares that pay a dividend depends on several important factors.
Firstly, the current and projected dividend payout. The dividend yield is derived from the current stock valuation and is set by the corporate board in the declaration of the company's annual results. While future dividend payments can vary based on the profitability of a business, a trusted board is committed to paying a dividend to the shareholders.
Secondly, the stock price during acquisition. The level of an acquisition price can impact the dividend yield. As the dividend yield is calculated by dividing the annual dividend per share by the current stock price, a lower stock price during acquisition results in a higher dividend yield and vice versa.
Thirdly, the potential return can be impacted by foreign exchange rate fluctuations. For investments in your portfolio that are not denominated in your domestic currency, the fluctuations in exchange rates can reduce the yield paid out to shareholders.
Finally, the outlook for interest rates and inflation can influence the outlook for income shares. If the interest rate is adjusted, it will impact income-bearing assets such as bonds and equities. If an increase in interest rates is not matched by an increase in the dividend paid on the income shares, then they will be seen as relatively less attractive compared to other investments.
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Stock selection
The next stage is to select the shares for the income portfolio. The level of the dividend payout is a major consideration, as is whether the shares are high-quality investments. For this, we need to determine whether the shares can be correctly classified as an income stock by comparing them to a benchmark.
Income portfolio construction
When investing in equities, income shares are considered at the lower end of the risk spectrum. Portfolio management companies will engage various measures to determine the level of risk, such as standard deviation and the Capital Asset Pricing Model (CAPM).
However, one of the popular ways investors can determine risk is by looking at the “beta” of a share. The “beta” is a measure of the volatility in the share price compared to the market. The higher the “beta”, the more volatile and risky the shares. Income shares tend to have a beta value of less than 1. Investors would also preferably be looking for shares with a dividend yield greater than the market. For that, they need to be benchmarked.
Benchmarking returns
Benchmarking for income stocks involves comparing the performance of a portfolio of income-generating stocks to a relevant market index or peer group, thereby determining how well the shares perform relative to the benchmark. That helps identify opportunities to optimise a portfolio's income-generating potential and ensure the achievement of any investment goals. Indices such as the S&P 500 for US stocks and the FTSE 100 for UK stocks are popular benchmarks to use.
Due diligence and the dependability of returns
It is always a good idea to look into the due diligence of the companies under consideration. Looking at the track record of the management in delivering on their business aims will help to identify the kind of company they are running. Solid and dependable companies tend to be the best income-share investments. A solid dividend growth history is another crucial factor to look out for. Furthermore, dividend cover is vital because if the dividend is covered at least twice by the earnings per share value, it is considered a dependable income-paying stock.
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Risk management
For a portfolio of income shares to build yield solidly into retirement, it must be managed correctly. Risk management is an important aspect, including the diversification of holdings and the active management of the positions.
Diversify your income stream
Diversification is a critical element of any portfolio. For income shares, there should be a broad selection of dividend-paying stocks across various sectors, such as financials, energy or pharmaceuticals. That will help ensure that if any company or sector faces a downturn, it will not negatively impact the portfolio.
Other factors can help with risk management, including investment in bonds, bond funds, or bond Exchange Traded Funds.
Cutting the losers
If certain shares are underperforming or have had their dividends cut, then there should be consideration of whether they deserve to remain in the portfolio. Selling the losers can enable a reallocation of resources into better-performing shares and forms part of successful portfolio management.
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Improving outcomes
Maximising the performance of the portfolio is an essential aim for any investor. There are techniques that every investor can employ to improve the returns of an income portfolio. Active portfolio management can also help to improve outcomes. Furthermore, if you consider yourself a “sophisticated investor, “options strategies are also available.
Here are a few ways to improve the performance of your portfolio of income shares.
- Investing in high-yield dividend stocks involves investing in stocks that pay higher dividends than the market average.
- Investing in dividend growth stocks: this strategy involves investing in stocks with a history of increasing their dividends over time.
- Investing in companies with strong fundamentals: companies with strong financials, such as solid earnings and cash flow, are more likely to be able to continue paying dividends in the future.
- Investing in undervalued stocks: investing in stocks trading at a discount to their intrinsic value can potentially provide higher returns over the long term.
- Investing in international dividend stocks: investing in international dividend stocks can provide diversification and potentially higher yields than domestic stocks.
Portfolio management
Buying shares and leaving them idle in a portfolio can work as a long-term strategy, but it may not ensure the best returns. Markets fluctuate, and share price performances can change.
Actively managing a portfolio's shareholdings can help improve investment returns. One way of doing this is by adding to winning positions and reducing exposure to underperforming shares.
Regularly reviewing and rebalancing a portfolio can help maintain profit potential and keep the portfolio aligned with your investment aims. Another way to improve the longer-term profitability is to reinvest dividends into the portfolio. Doing so will help the continued growth of the pot. Taking the dividend as cash might seem like a nice bonus, but it can negatively impact a portfolio's long-term profitability. This is especially true with investors who are not in or close to retirement.
Covered calls
Increasing the level of risk can increase the rate of return on investment. Sophisticated investors will often use options strategies to help boost returns.
A “covered call” strategy is used with income-generating stocks to generate additional income from premiums received by writing call options.
The investor writes (i.e. sells) call options on stocks they own. This generates income in the form of premiums.
However, it is essential to understand that this is a high-risk strategy that only plays well in market conditions where the share price volatility is very low. Investors should be aware of this strategy's potential risks and limitations, including missed opportunities for price gains and potential losses if the stock's price decreases significantly. There are also tax implications to using options strategies, so if you are uncertain, it is a good idea to ask a financial advisor for more information.
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Final Thoughts
Share portfolio creation and the management of income-generating share pools are covered by a plethora of surrounding research and support materials. Take your time to make the best decisions for you, as these are shares you will hold for years, even decades, before reaching your investment objectives. Carefully planning and executing is just as critical to your expected outcomes as the underlying performance of the companies themselves.
Always do your due diligence and consult with the experts where you can. Asktraders has made a wealth of data and information available; ensure you read up and understand what you're getting into before making any investment decision.
