If you are investing in stocks and shares for income, as opposed to items such as bonds, UK government gilts and, probably, US Treasury Bills and Certificates of Deposit, there are some things to consider.
Why Choose Stocks and Shares
An initial question would be why, if you are investing for income, you would consider stocks rather than bonds and similar types of investment. The main difference is the potential of capital growth - and therefore asset protection - for stocks is higher. Conversely, the prospect of capital loss is also greater. This capital growth potential means that the income can be solely used to live on, rather than having to be reinvested in order to maintain your investment's value when allowing for inflation.
This capital growth is something that is often not seen in bonds and gilt-edged stocks, although the UK gilt market has the potential for capital gains - if you invest at the right time. It also has the potential for capital losses if you don't and cash out at the wrong point. Buying a gilt at issue and keeping it for the full period means that you will just earn interest on the gilt, and no growth from changes in the price. Gilt-edged stocks, or gilts, are fixed interest primarily UK government securities, but there are other, similar investments around.
Investing in Gilts
The right and wrong point to buy and sell UK government gilts depends on the current interest rate and the interest rate of the gilt in question. After issue, the price of the gilts vary as interest rates change, so that the actual interest earned from an investment is not the same as the face interest - a gilt that earns 7% on a face value of £100 may actually sell at £175 and yield an actual interest rate of 4%. When interest rates go up, gilt prices go down, and when interest rates go down, gilt prices go up. This keeps the yield on a gilt in line with current interest rates. Gilts are therefore best bought at times of high interest rates, when they are at their cheapest, and sold when interest rates fall, when the gilt has gone up in value. This primarily relates to investing in gilts in order to make a capital gain.
Capital growth may not be as important factor when stocks and shares are being purchased for their income generation value, rather than their growth potential, but it can be still useful, especially when it is being used to protect the value of the investment from being eroded by inflation. If the price of an investment stays stable then, no matter how low inflation is, it will still lose value. If interest is being reinvested, this loss is decreased or mitigated completely, but if the income is being used to live on, capital growth becomes more important.
If you have an investment of £100 (or dollars, or whatever) and inflation is 1% then, after one year, you will need £101 the next year to purchase what cost £100 in the previous year. This loss of purchasing power and actual value needs to be covered somehow by growing the investment at least that rate. Inflation is why money invested in savings accounts, which have very poor interest rates that are usually below the rate of inflation, actually lose real value, decreasing the investment's worth, rather than increasing it.
With income generated being the primary factor when investing in shares to create a good, constant cash flow, capital growth is less important. There are other factors that are much more important to look into. Picking the right shares, and then keeping them, will be the plan to follow. As the world's greatest investor, Warren Buffet, says "Our ideal holding period is forever." This doesn't mean that you won't need to sell shares at some point, especially if there income producing potential decreases.
Picking the Shares to Invest In
When choosing a share for its income (dividend) potential, merely choosing the company that is giving the largest dividend is not enough, and can be dangerous to your investment. It is possible that a company may be selling the silverware in order to keep up their dividend payments, which means that the company is in serious trouble and is being miss-managed. This is the sort of investment you want to steer clear of. These are some factors to consider.
Credit: SXC.HUThe company's dividend history is important. A good dividend this year may be a one off due to an unusual item or distribution of cash to shareholders. Whilst these are good in a stock you own, one year's performance should not be the basis of choosing to invest your money. What you need to look for is a company that consistently pays out a decent dividend.
Another thing is what is the percentage of profits that are paid out in dividends. The higher the percentage of profits that are being paid to shareholders, the greater the likelihood that a reduction in profits will result in the reduction of the dividend paid out. It may also be a sign that too little is being reinvested in the company itself. A dividend that equals 90% of the profits made is likely to be unsustainable.
Dividend growth, or how the dividend payment increases over time, is also important. A company should have a constantly, and consistently, growing dividend. This will help your income keep pace with inflation. If the dividend growth does not keep pace with inflation, this will result in less buying power as time goes by, as mentioned earlier.
Mutual Funds and Unit Trusts
There are mutual funds and unit trusts available to purchase that make a specialty of buying good, income generating shares. Investing in these is a way of getting shares that have been researched that will hopefully generate a good, safe income from dividends.
However, you do not need to invest in these funds to benefit from their research. You can purchase shares in the funds if you wish, but if you are thinking of investing a large amount, which is quite likely if you are investing for income, as small amounts won't generate much, you don't need to actually buy the funds. Instead, it is possible to find out what stocks these funds are holding and buy them yourself. There will be an initial cost for purchasing the shares, which may be higher than you would lose investing in the mutual funds and unit trusts, but there will be no annual management fee. Management fees can add up over the years, decreasing your income.
Wrapping it Up
Investing in stocks for income is different to investing for capital growth. It may lead to capital growth, because a good, solid company with a good, solid dividend is likely to grow in value, simply by being a decent investment. Undervalued companies are good to look for, as they often give a higher rate of return on your original investment, and it is the return on your initial investment that is the most important. If a company goes up enough that the actual rate of return drops, it can be worth switching to another, undervalued share.
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