In my previous article about investing for income, I explored a brief checklist of ideas for selecting income stocks and building an income-focussed portfolio. In today’s article, I’ve assumed that you’ve gone ahead and selected a few shares that fit these criteria and are now wondering how to manage them. I’ve written multiple articles before about portfolio management, but today’s article will be focussed specifically on those issues more pertinent to an income-seeking investor.
Just as when initially selecting your investments, it is a good idea to create a set of rules and criteria that will enable you to figure out when you might want to sell or reduce a holding. For example, if a share price rises faster than the dividend, then the yield of that holding will decrease over time. If the yield falls far enough – say, below 2%, then you may want to consider reducing your holding and reinvesting the proceeds in a higher yielding company.
Likewise, if a share price declines, the yield of the shares will rise. For example, if you purchase a share at 100p and it pays 5p a year, your initial yield would be 5%. If the share price drops to 90p, then the yield would increase to 5.5%. Providing that the dividend is still covered by earnings (see part 1 of this series), then you may wish to top up the holding to increase your yield.
Having said this, simply buying when the yield rises is not always a wise idea – sometimes the share price is declining due to valid concerns in the market. It is always critical to ensure that you have a good understanding of your holdings when investing for income – both their prospects and management, but also the dynamics of the wider industry and market in general. For example, if the market is broadly falling because of general concerns about economic data, but the business in question was considered defensive, you may decide that the price decline was overdone and decide to top up. If, on the other hand, the share price was declining because the CEO had recently been caught covering up a huge IT scandal resulting in a massive lawsuit, you might want to avoid piling into a distressed asset.
Dividend Reinvestment
As an income-focussed portfolio, your holdings will naturally generate a certain level of dividends each year. The natural conclusion is that you will withdraw these to fund expenditure but there is an alternative – Dividend Reinvestment. This is where the investor receives dividends and uses them fund additional investments. Some companies offer an automatic method of doing this called a Dividend Reinvestment Plan (or DRIP).
Effectively, a DRIP withholds a cash payment from the business and instead issues the investor with additional shares at a fixed market rate. So, if the shares are valued at 100p and the investor would normally receive a dividend of 500p, they would instead be issued with five shares of the company. Personally, I am not a huge fan of these programmes as they usually incur dealing costs and also prevent the investor from selecting the price at which they are converting their dividends into additional shares. If the share price fell under 100p in the weeks after the dividend was paid, the investor would have been able to pay more shares, or at least to have paid less for the five shares they would have received.
Instead of using a DRIP, I allow dividends to accrue in my cash balance and reinvest them periodically in either an existing holding at a good price, or a new holding I have been researching.
When to Sell a Holding
As a rule, an income-focussed investor won’t want to sell shares regularly providing the dividends remain covered and continue to grow over time. Having said this, if a share price begins to grow more rapidly than the underlying dividend, the yield will fall – if it falls below a certain level, say 2%, you may wish to consider reducing your position. This is never a cast-iron strategy, however, and following this rule religiously could see you selling strong companies with excellent prospects and replacing them with struggling or stagnating companies instead.
This approach does, however, enable you to benefit from capital gains – which is a valid source of income. For example, if a 5% yield is paid on a £10,000 holding, the investor would receive £500 a year in income. If the share price rose 5% and the investor then sold £500 of shares, they would receive an income of £500 and still own a £10,000 position in the company. This second method is equally as valid to generate an income but does come with the risk of ‘cannibalising’ your portfolio over time. In some instances, this may be appropriate but income investors should always, in my opinion, be wary of spending significant chunks of capital as it makes it gradually harder to generate a return over time.
Instead of this, the bigger cause of selling shares for an income investor could be based on underlying performance of the business, which is an approach much closer to my own. For example, if earnings per share (or the amount of earnings attributable to each share of the company) begins to decline, debt begins to increase, or revenue begins to stagnate or decline, I am more likely to move on from a company a sell it. As an income investor, your primary concern is the company’s ability to pay and fund a growing stream of income over time. If earnings decline, that stream of income is threatened – likewise, if the business is accruing significant debts.
Rebalancing
If an investor had £100,000 to invest and invested £5,000 equally in 20 companies, they would have an equally balanced, diversified portfolio (providing they had followed the usual criteria of diversification such as sector, size, geography etc.).
Over time, some companies would be expected to do well, others average, and perhaps one or two may decline in price. As these changes were priced into the share values over time, the portfolio would become unbalanced – becoming more heavily concentrated in those companies with the greatest share price appreciation and less concentrated in those that had done the worst.
This in turn would unbalance the risk profile of the portfolio. For example, let us say that one share doubled in value, going from a valuation of £5,000 to £10,000 whilst another share halved in value from £5,000 to £2,500. In this scenario, the investor faces losing 10% of the portfolio value if the first company went bankrupt but only 2.5% if the second company went bankrupt. The greater these distortions become, the more volatile your portfolio will become and the greater your risk grows in those positions that become outsized.
For this reason, it is important to set limits on position sizes in your portfolio in line with your risk profile. For example, you could set a limit of 8% for any individual security and no more than 12% in any fund. In addition, you could ensure that positions that begin to nudge these limits pass rigorous quality criteria, say dividend cover of at least 2x, debt of no more than 1x total assets, earnings per share growth forecast of at least 5% per annum, and operating in a sector you understand with minimal operational or political risk, to help further minimise their risk over time.
Responding to Market Crashes
From time to time, the stock market will throw an absolute wobbly and begin to mark down companies at an alarming rate. Most days you will see a sea of red in your portfolio with individual positions multiple percent on a daily basis. In my ten years investing, I have faced a number of these markets, and without a doubt, they always give you a bit of a sinking feeling – especially when they persist for several weeks or months.
For the income investor, a market crash is a real opportunity to load up on quality assets at cheap valuations. Blue chip companies that normally yield 2-3% will suddenly be available at yields of 5%+. Some small cap companies can easily get into the double digits and the market will be throwing more opportunities at you than you will know what to do with.
Without a doubt, it isn’t always a natural instinct to climb out from behind the sofa and get on the phone to your broker to start buying (or hammering your app for the youngsters) but this if you can stay calm and focus on your long-term priorities then this is undoubtedly the time to be loading up. Likewise, your own portfolio will be taking a beating but if you liked the companies yesterday then today they’re available at a discount – why wouldn’t you be buying?
Remember, when investing for income, your goal is to maximise the yield of your portfolio. As long as cash keeps rolling into your account from the dividends, you don’t need to be too concerned about capital value (providing, of course, that you haven’t loaded up on totally speculative JunkCos that are going to zero!).
Withdrawing Income
So far, we’ve mostly talking about the management of individual positions – but what about the income? Again, let us say that we have a £100,000 portfolio generating a yield of 5% – £5,000 in annual income or about £416 a month. How much money could you withdraw from the portfolio each year before you ran out of money?
Ultimately, determining “how much money can I withdraw” comes down to balancing the withdrawal of income with its generation. If you consistently withdraw more income than the portfolio is generating then eventually the portfolio will have nothing left.
When I first began investing, I heard that about 4% of the portfolio value was safe to withdraw each year, so in this example, that’s about £4,000 a year, or about £333 a month. This figure is based on historical equity returns of about 10% annualised, meaning that the portfolio would grow to £110,000, and have £4,000 withdrawn over the course of the year, reducing the value at the end of the year to £106,000.
In theory, this works fine, but in reality that 10% equity return is far from guaranteed (and is based on US equity returns from 1926 to 2021). There are a few problems with the model that I can see:
- If we accept that returns are neither guaranteed nor smoothed over time, it is possible that in the first year, the portfolio loses value at the same time as the investor is withdrawing capital. This would result in a lower portfolio value at the end of the year, and therefore a lower expected income in the second year (unless the investor ignores the 4% rule and keeps their income at the same level).
- If dividends are reduced for the year and the portfolio fails to generate 5%, returns could be lower than expected (as our 10% expected return included dividends).
- If the investor holds a market other than the US (or if the US fails to continue to return 10% annualised returns), the model falls over.
My personal rule of thumb is to withdraw approximately 75% of income generated by the portfolio and reinvest the remainder. In theory, if the portfolio’s dividends were being paid from companies with reliable income streams, this would enable income to be grown over time (hopefully faster than the rate of inflation), whilst also increasing capital over time.
NOTE: Shortly after I started writing this article, Ramin Nakisa of Pensioncraft published an excellent video on this topic – well worth taking a few minutes out of your day to watch it (and also subscribing to his channel, which is packed full of great investing content).