Jargon is the enemy of financial advice, but it abounds in our industry, with phrases like ‘Income Investing’ or ‘Total Return Investing’. Exactly what does it all mean?
Income investing is where you structure your portfolio to provide a regular ‘natural’ income, normally in the form of dividends from shares in companies, or interest from loans made to governments or companies (bonds). This was traditionally the way individuals invested if they wanted to supplement their pension income. Examples of shares commonly held in income portfolios are British American Tobacco (BAT), Diageo, Royal Dutch Shell, long-established companies in mature markets.
Total return investing typically focuses on growth rather than dividends and you would supplement your income by taking both dividends and capital withdrawals. Examples of growth stocks are companies like Facebook, Apple, Amazon, Netflix and Google (collectively known as FAANG).
Income investing sounds good. You buy shares which should grow over the long term as well as generating income through dividends. What are the drawbacks?
Well, the first thing is you are reducing your investment choice. If you are targeting companies that pay good dividends, it means that you are automatically excluding some excellent companies from your portfolio because they are not paying high dividends. This concentrates the exposure to a specific type of company. Reduced diversification means increased risk.
Additionally, you are unlikely to see substantial growth in capital over time. The more money a company pays out in dividends the less money it can reinvest for growth. A large portion of your investment return will be in the dividends you receive. If you had selected BAT as a high dividend paying company in January 2015 and bought shares, you would have enjoyed dividends of around 25%, but the share price has fallen by almost 13%. This is typical of an income stock, little capital growth but substantial income from dividends.
Thirdly, dividends are not guaranteed. You will only receive a dividend if there have been enough profits in the business and management decides to distribute some of those profits to investors. When that profit is at risk, as is the case for many companies during the COVID crisis, dividends are one of the first things to be reduced or scrapped completely. So far this year, 46 of the UK’s largest 100 companies have reduced or deferred their dividends. This is estimated to be about £30bn of dividends not paid out!
Finally, you are likely to have to take more investment risk to meet your income need if you are only going to spend the income and not your capital, particularly when interest rates are low and alternative income streams, such as interest payments from bonds, are not as generous.
If you needed £20,000 of income from a £500,000 portfolio, you would be looking to target dividends of approximately 4% of your portfolio. The UK stock market currently yields approximately 4.6% so almost all your £500,000 would have to be in shares if you were trying to target £20,000 of dividends.
So how is ‘total return’ investing different?
Total return investing provides greater investment choice. You can hold companies that pay good dividends and companies that have good growth potential. You could hold income shares like BAT, but you could also hold companies like Facebook, Apple, Amazon, Netflix and Google, the FAANGs, which are growth orientated companies. Holding more companies spreads your risk. To put it into context, our portfolios have approximately 22,000 different holdings!
You also get greater tax efficiency. If you are drawing capital and dividends, then your dividends will be subject to income tax, but your capital may escape tax altogether due to a generous annual exemption. If you already have a high income from other sources, then you will likely be paying tax of 32.5% or 38.1% on dividends of more than £2,000. If you are drawing capital, you will pay tax of either 10% or 20% on any profits realised, but only when you exceed the annual exemption of £12,300.
However, in the same way that dividends are not guaranteed, neither is capital growth. As we have witnessed in 2020, stock markets do not go up all the time.
Taking the same £20,000 income need, generating this entirely via dividends means an income tax bill of £5,850 for a higher rate tax-payer.
Alternatively, if the £20,000 was generated from profits in the portfolio, you would pay £1,540 in tax. That’s a tax saving of almost 75%.
So, there are benefits to total return investing, both in terms of tax planning and portfolio diversification, but there are times when income investing has a place so we don’t automatically discount either. It will always come down to your own circumstances and what works with your wider financial planning.
Gary Wright is a Financial Planner at Carbon and can be contacted at email@example.com
The value of investments and the income derived from them can fall as well as rise. You may not get back what you invest.
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