|A different perspective
What I want to explore here is not so much the deeper meaning of life (and how it should be lived) but rather the concept of investing as part of a difficult life journey. There is no easy route - and each of us must find our own approach.
To be clear, I'm not saying that amassing wealth (or even trying to maintain it) is the purpose of life, but that is rather part of a process that enables a wider range of choices. Money does not buy happiness - but it can certainly make you more comfortable.
Coming back to the theme of Income Investing: this aspect of life seems has become more difficult. On the surface of it the DIY Income Investor approach seems to be working in a satisfactory manner. Most obviously, the estimated annual income of the portfolio - perhaps the single most important indicator - continues to hit all-time highs. The value of the portfolio also has been recently hitting all-time highs, indicating that this income is not just being bought at the cost of capital value.
One aspect of this style is that there is a regular need for renewal - cash is continually being thrown off (in the form of income, as well as sales of 'successful' purchases) and needs to be reinvested. That is where the Income Investing approach becomes less of a science and more of an art. As I have written several times before, a focus on income leads to an interest in higher-yield investment securities and these are typically those that the Market has shied away from, perceiving higher risks.
So you can 'buy the market', with a yield of around 3% (for a FTSE 100 index) or you can take a bit of a gamble on something with twice that yield. Whether the risk is twice as much is the fundamental question. Is the Market inherently over-conservative or over-cautious? Or is everything with a higher yield really more risky - meaning that a successful high-yield investor is just lucky?
The Tao of Income Investing is this: the investment approach is inherently risky but can these risks really be mitigated in the longer term? To be successful, the key decision is the assessment of risks when buying. The decision on when to sell is also important - but that can be formalised more easily with selling 'rules'.
Risk and return: let's consider this in a little more detail. In the DIY Income Investor approach, there are three main sources of income:
- cash, with a range of accessibility (in the sense that you put your money temporarily out of reach), with yields ranging up to 5.6%
- share dividends, with yields occasionally peaking up to double digits, but with sustainable yields probably around 3-6%
- fixed-income securities of all flavours (i.e. including bonds, preference shares, PIBs, etc.) with the higher-yield end of the market up to about 6-7%
- (there are obviously other sources of income - like blogging [ha, ha] - but I don't deal with those here)
Now, you might think that a cash return of 5.6% (for a 5-year loan) must be inherently risky - but have a look at peer-to-peer lender RateSetter's latest evolution. Their key differentiation is their bad-debt reserve fund (recently renamed the '100% Fund') and their claim: "In 2010 we set out to ensure not one single solitary saver lost even so much as one penny lending through RateSetter. £214,977,944 later we’re proud to say not one of our 12249 lenders has." Early days, perhaps, but as a business model in a low interest rate environment it looks like a winner. I wish I could buy shares in it!
So much for the risk premium, if 5.6% is virtually risk-free.
Then look at dividends. Most of the FTSE 100 companies pay dividends - but most don't pay very much. The FTSE 100 has a yield of 3% while the current top-yielder is Resolution, with a yield of 7.3%; compare this with current non-payers such as Persimmon, Standard Life and Lloyds (all of which are expected to resume payments). What is actually the difference in risk between the high-yielders and the non-yielders?
Finally, the yields on fixed-income securities move in reaction to many concerns, including currently the expected unwinding of QE, which will inevitably result in a fall in price of government securities around the world (so increasing their yield). So, 'yield' in this context is as much as an indication of risk to capital (and income) due to default as also a risk of capital loss due to wider market evolution.
The point I am trying to highlight is that, although there is clearly a link between yield and risk, it is not a clear and direct relationship - it is much more subtle. And therefore there are opportunities, if we can pick our way through the noisy and conflicting messages coming from the Market.
That said, it is not easy. I don't like holding cash in my brokerage accounts, as the yields are trivial, so I need to regularly reinvest. (Most cash is held separately - although this may change with the recent proposal for changes to UK ISA/SIPP rules). And this is particularly difficult at the moment, with no clear direction to the markets. Fixed-income is problematic at the moment (given that they will all go down in price soon), leaving dividend shares. I can't find any new dividend ETFs (and I am fully invested in the ones I already own - up to the approximately 5% ceiling on any single security). So that leaves direct investment in dividend-paying shares.
When there is nothing new that inspires me in the Market, I usually fall back on topping-up my existing holdings. My latest, slightly reluctant, choice is HSBC (LSE:HSBA), with a forecast yield of 5.2% (current yield is only 4.7%). I bought HSBC under a year ago, marking my return to the banking sector. And having just sold my two long-standing bank shares, Lloyds and RBS, I thought it was a good idea to top up a bit more in the sector (I also continue to hold Barclays). The concerns I had when I first bought still remain.
But that's just the Tao for you.
[Purchase price: £6.145]
I am not a financial adviser 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.