How should you choose which asset class to invest in?
The asset classes used by the DIY Income Investor approach are identified in the Income Pyramid (from the bottom upwards):
- Level 1) Cash in an online bank/checking account
- Level 2) Cash in a high-interest 'easy access' bank account
- Level 3) Cash in a fixed-interest fixed-period bond
- Level 4) ETFs
- Level 5) Government bonds
- Level 6) High-yield shares
- Level 7) Corporate bonds The line between Levels is a bit blurred but investing directly in shares, gilts and corporate bonds may not be for the novice DIY Income Investor - starting with ETFs may be a better introduction.
Within gilts and corporate bonds there are two flavours: 'perpetual' and 'dated' (depending on whether a maturity date is identified). These have slightly different risks and advantages. The perpetual stocks can be seen as a kind of 'underlay' income that, although it is terribly exciting (in terms of rate of return), keeps delivering - year after year. With the ups and downs of the economic cycle it is sometimes possible to pick up good rates of return, 'locked in' over many years.
How much you put in each layer of the Income Pyramid depends on a number of factors, including the size of your financial resources, your attitude to risk and the need to retain reasonable levels of liquidity to allow for any unforeseen expenses in life.
As a guideline to asset allocation:
- Level 1) You really need a couple of months' expenditure in ready cash
- Level 2) 'easy access' cash should be equivalent to 3-6 months of your individual or household expenditure
- Level 3) fixed interest cash bonds/cash ISAs should bring up your total cash (in Levels 1 and 2) to at least around 12 months of expenditure
- Level 4) ETFs should allow you to double your cash holdings
- Levels 5-7) gilts, high-yield shares and corporate bonds: you can begin to introduce these as your wealth grows - always looking to make your money work hardest by generating income, but without taking substantial risks
You should only move to higher levels when you have achieved the suggested levels of investment in the previous levels. In this way you will gain financial security, knowledge and confidence. You may not even need to move beyond level 4 (ETFs), unless you have a real interest in maximising your income.
Sweat your assets
At the heart of the DIY Income Investor strategy is the focus on making your money work hard generating income. The approach means that it is easy to compare the rates of return (yield) that each asset class is producing.
If the yield or interest rate available in one asset class (for example gilts) becomes more attractive, you may want to increase that layer of your Income Pyramid. To maximise income you will need to shield your savings and investment from tax, as far as is possible.
For example, my current DIY Income portfolio (in my and my wife's names - for tax purposes) is split up approximately as follows:
- one-third in cash bonds
- one-third in ISA high-yield shares
- the remaining one-third is split:
- two-thirds in ISA gilts and bonds (only around one-fifth in gilts)
- one-third in 'easy access' cash