Investing for income can be about harnessing the power of dividends to boost your investment returns, or using the stock market and bonds to increase the money you have to spend.
In our new series on investing for income, James Norton, senior investment planner at Vanguard, will explain what you need to know, the investments to look for and the pitfalls to avoid.
It is aimed both at those growing their wealth through their working years – and using the money they have built up to fund retirement.
Investing can either boost the income that you have or grow your wealth over time
Investing for income
When the time comes to retire, many investors are unsure of the best way to manage their portfolios.
Some pursue strategies that increase income, not fully realising that their exposure to risk has also increased. Others fear touching their capital, worried that they will run out of money.
But income investing is not just for retired investors – dividends are also a vital part of growing your investments.
This series of articles will tackle the many aspects of income. We’ll look at the accumulation phase, when you are trying to grow your wealth, and the drawdown phase when you are spending from a portfolio in retirement.
You may be surprised by our suggestions, as they may challenge you to think about income in a new way.
In this first part we look at the main types of income that investments can generate and the role of income in building portfolios.
Interest from bonds
James Norton of Vanguard explains investing for income in our new series
When it comes to investing there are two main types of income: interest and dividends.
Most of us are familiar with interest from bank savings accounts. Interest from fixed interest investments, or bonds, is similar.
Bonds are essentially loans from investors to companies or other bodies such as a government.
In return for the loan, the issuer (borrower) will pay interest, usually once or twice per year. At a pre-determined date in the future, the loan is repaid in full.
Just as with a bank account, with any individual fixed income investment you know what interest you’re going to be paid.
The interest rate a bond will pay depends on a number of factors. If the company or government issuing the bond is stable and low risk the interest rate will be low, as investors have a high chance of getting their money back. A higher-risk borrower on the other hand, will have to pay more.
Interest rates are also affected by prevailing rates in the market when the loan is issued. As we all know interest rates are low at the moment (but trending higher), so new bonds will generally have low rates of interest – usually just a little more than you could get with a bank deposit.
Dividends from shares
The income paid by equities (shares of company stock) is called a dividend. When you own a share, you own a part of the company. So when that company pays a dividend it is effectively paying you a bit of the profits.
A well-managed company making healthy profits may well be able to pay rising dividends over time, but there is no guarantee. And if profits fall, dividends could be cut.
Many companies choose not to pay dividends at all, and this is not necessarily a sign of company weakness. Some companies, for example, decide to reinvest profits by hiring new workers or building new facilities rather than paying dividends.
This approach is favoured by many fast growing companies including some of the largest and most successful firms in the technology sector.
With dividends reinvested, £100 invested in the UK stock market in 1899 would have grown to a staggering £28,232
The power of income
Whilst many of us crave income from our portfolios during retirement, not all of us are aware of how important income can be in growing a portfolio.
Want evidence? The 2016 Barclays Equity Gilt Study shows that without reinvesting dividend income, £100 invested back in 1899 would be worth just £184 today (after inflation is taken into account).
But with dividends reinvested, that £100 would have grown to a staggering £28,232. As for bonds, with interest reinvested the account would be worth more than 600 times more than if the interest had been spent.
In other words income is a vitally important part of the total return of your portfolio.
Next time: In the next article we’ll look at income – and its sources – in more detail. It will be live on This is Money this week. Sign up to our newsletter to be sent the this series of articles as they are published.