Everyone wants income these days

I have long been a fan of income-orientated strategies. Not because the returns from income are necessarily always superior to total market approaches – though at times they can be – but rather because a focus on chasing capital gains can be so ruinous.

Not every decision in investing needs to be about maximising your theoretical return – there are other risks and rewards to think about, such as the risk of getting carried away, or the reward of being better motivated to reach your goal.

Accordingly, I believe in normal times many people would do better focusing on investment income rather than their net worth when calibrating their financial freedom plans.

But these are not normal times. Now it is expensive to have a taste for income:

  • Cash was yielding 5-6% half a decade ago, provided you were happy to chase the best rates. Now it pays 2% at best.
  • Long-dated UK government bonds will get you less than 2% a year. Gilt yields above 6% were the norm in the 1990s, and 5% was still possible before the financial crash.
  • The only shares the market truly loves are dividend paying shares, which has brought the yields down on many of the HYP favourites

Today’s low yields may prove to be rationale, and we’ve warned before you may come a-cropper if you eschew cash or bonds in disgust at their miserly yields.

Personally though I’m happy to take the risk of holding zero bonds (I’m a more than semi-active investor, remember, unlike my nobler purely passive co-blogger).

I do maintain a larger cash war chest than I otherwise would though, and indeed am about to add more to Zopa.

Coke is it

As yields have been pushed down across the fixed income classes, some safety-first investors have tiptoed into equities.

I suspect this is what has led to the most defensive-looking shares – utilities and the big consumer staples companies, as well as healthcare – doing so well.

You can also see the popularity of dividends in investment trust premiums and discounts. The equity income investment trusts long ago moved to a premium, whereas many global growth trusts still sit on big discounts. I’m just working through the update of my demo high-yield portfolio for next week, and I’ve noticed my comparison basket of income trusts have truly been on a tear – up nearly 28% in capital terms alone.

When a supposedly safer investment gets more popular, the price appreciation means it’s probably become more risky.

Sure, companies like Diageo and Coke will always be more predictable than miners or metal bashers.

Whether the shares are a safer investment comes down to the price you pay. If people are paying too much for boring dividend stocks, then they will get lower returns than usual in the future.

Hunting high and low

Active investor David Schwartz touches on this theme in his article in the Financial Times. (The link leads to a search list, the article should be up top).

Schwartz writes:

At first glance, a high-yield strategy looks to be worth pursuing. Profits from a steady investment within the high-dividend universe rose by 123 per cent in the past 15 years, assuming dividends were quickly reinvested.

In contrast, a low-yield investment approach resulted in a gain of just 41 per cent.

But the trend was reversed when a 10-year timeframe was used. Low-dividend shares gained 179 per cent since May 2003, against just 135 per cent for higher yielding shares.

Low yield shares did particularly poorly around the time of the dotcom crash, because so many tech firms blew up. In addition, steady ‘old economy’ companies had been shunned for years, which meant they were relatively cheap and sported high yields in 2000.

But very different conditions prevail today.

I’m not suggesting you should now blindly buy low yield companies instead of high yield ones. Passive investors should as always follow the principles of strategic ignorance and simply stick to their asset allocations. Active investors should be wary of any cut-and-dried ‘rules’ at all.

However the steady media and adviser commentary that’s pushing investors towards dividend-paying stocks does seem like an accident waiting to happen:

  • Firstly, all share prices decline from time to time. How will bond investors turned reluctant dividend-chasers cope when this bull market finally ends and their portfolios wobble?
  • Secondly, according to Schwarz low-yield shares are actually outperforming since 2009, despite the fad for income.

The dividend-chasing I’m discussing here has been most evident over the past 6-12 months, and is mainly a blue chip phenomenon, rather than a market wide one. I don’t think high yielding cyclicals are being targeted, for instance, which may explain that post-2009 result.

I also suspect Schwartz’ short-run data may be skewed by BP’s problems, and by the scrapping of bank dividends during the crisis.

As banks like Lloyds and RBS start paying dividends again, these low-yielders may deliver strong returns as they move back to being the higher yielders of tomorrow.

Consensus is costly

Let’s not get carried away with any of this. Schwartz’ analysis only covers 15 years – a blink of an eye in market terms. It doesn’t prove anything in particular.

Also, a big bonus of income-focused strategies is they substitute trying to trade for profits or even going for total return for simply building up your income streams. When you’re ready to spend the income instead of reinvesting, you just start to spend it.

In my experience income strategies also tend to be less volatile, with reinvesting the higher income helping to further cushion the downside.

All this has advantages (mainly psychological) that may even outweigh the pursuit of the greatest total return that is theoretically available from buying the entire market. Some people may therefore still rationally choose to buy equity income trusts on a premium, for instance, or income-orientated ETFs that may contain relatively overvalued dividend paying shares, even if returns prove to be a bit lower than from racier alternatives – especially if they’re refugees from the bond market.1

Tastes wax and wane. Back when I first got seriously interested in investing, a company’s shares sometimes got dumped for initiating a dividend payout! Growth was everything to a lot of people. Today the opposite seems to be true.

I don’t think even the blue chip consumer-focused dividend payers that are now so popular are in a bubble, exactly, although their multiples look quite stretched in many cases.

But if you’re buying higher-yielding stocks in this market – especially the so-called ‘aristocratic’ dividend payers – because you expect them to deliver higher returns than equities overall, well watch out.

Being in with the popular crowd has never been a route to investing riches.

  1. Personally I would prefer certain of the larger global trusts still on reasonable yields and discounts, but each to their own.

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