Saturday 29 September 2012

The Mind of a DIY Income Investor

Your actions are a result of your thoughts - and I think a DIY Income Investor needs to be a thoughtful (and patient) type of investor.
Let me tell you a little about what has formed my own DIY Income Investing thought processes.

To start at the beginning, for any investment, the way I look at it is:

Total Return = Capital Gain (or loss) + Income

(where income might be in the form of interest, dividends, coupon, etc.)
Historically, stock market returns are actually heavily weighted toward reinvested income (dividends) rather than capital growth. So, it is perhaps not surprising that Income Investors (like me) concentrate on the income side of the equation - but obviously not ignoring what happens to the value of the original capital investment. Thus, for the Income Investor, although obtaining a good income or yield is the main objective, there must still be consideration of the potential for capital loss or risk.
But the most insidious part of being an income investor is that you are forced to articulate what your income is actually intended for. Most probably it will be a long-term goal of early, or at least more comfortable, retirement - although other shorter-term goals are obviously possible.

And what is more, the corollary of this line of thinking is then: ‘well, how much income is really necessary’, which leads - inevitably - to the question ‘how much expenditure is necessary’.

Here’s another simple equation, what I call your Wealth Potential:
Wealth Potential = (Income - Expenditure) * Investment Yield

In other words, your future wealth is achieved by successfully investing the net surplus of income over expenditure. Moreover, you can apply your efforts to both income and expenditure: reduce expenditure by half and you have more surplus income to invest, generating even more income - creating what I call the Income Snowball, rolling faster as it gets bigger.
Expenditure includes debt payments, and it usually makes sense to reduce your gearing (or negative capital) - with the exception of a mortgage - which, nevertheless, I would recommend paying off as quickly as possible.
There are many potential sources of income or yield, each with different risks. The main source during your life is likely to be your job but passive income from savings and investment can supplement - and eventually replace - this work-related income. Your work may also provide the opportunity to: a) invest in a pension and b) buy shares in your company.

So, taking this approach, it becomes quite easy to steer your way through life financially. Compare your passive (investment) income with your expenditure - current or in retirement - and you have a good indication of your progress towards your financial goal. You can steer your way by either:
  • increasing income
  • reducing expenditure
  • increasing yield

And as regards increasing yield - beware! If you believe that markets are efficient (although somewhat over-excitable) - with some rare exceptions - then the yield on offer is usually a good indication of the risks involved, even if you don’t immediately understand what all the risks are. There are very few ‘free lunches’. High yield goes with high risk - so a defensive attitude is required: diversify!

To deal with this risk spectrum I have developed what I call the Income Pyramid, which is built up of layers of different types of income investment, starting at the bottom with effectively ‘risk-free’ cash and rising in complexity (and risk) to instruments like dividend shares, corporate bonds, PIBs, preference shares and other types of securities.
The satisfaction that comes from watching the investment income trickling in - hopefully with an increasing flow - has to be experienced. And when the end of work arrives, you have a fascinating hobby to develop: managing your portfolio.

(A version of this article was published previously on CityWire Money.)

I am not a financial advisor and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

1 comment:

  1. This is great. I have a hard time trusting other people with MY money. That's what I like about the idea of DIY Investing. Thanks for this.