In today’s Income Insights, in an article excerpted from The MoneyLetter, The Investment Reporter Editor Marc Johnson lays out some of his rules for designing a growth-and-income portfolio that won’t expose you to too much risk.
“Trying to squeeze income and capital growth from a single portfolio is the right choice for many investors. At the same time, however, it can lead to costly errors. But you can do it if you pay attention to some basic rules.
“One drawback to building an income-growth portfolio is that it calls for investment in two distinct kinds of securities, with each having their own subtle and not-so-subtle risks. Some investments are appropriate in a growth-seeking portfolio, but not in an income-growth portfolio. Cyclicals—mainly resource and manufacturing companies—should play only a minor role in an income-growth portfolio, because of the risk of dividend cuts and omissions. Few resource and manufacturing companies pay dividends that continually rise. Overseas stocks should also be kept to a minimum, because they’re volatile and hard to follow. You should altogether avoid stocks that have yet to establish a record of profits, much less dividends. You should also downplay long-term bonds because of the inflation and interest rate risks.
“Many hybrid investments offer a combination of income and growth, or of above-average income with diminished security. At the top of this list, I put fixed-income preferred shares. They’re generally not liquid and when trouble strikes, a firm can quit paying preferred dividends as soon as it quits paying common dividends. In a liquidation or restructuring, preferred shareholders often do badly. I’d say the same about most bonds and preferreds that come with so-called ‘bells and whistles’ such as rights and warrants as sweeteners. You almost always give up too much income or security in return for these features. Often it’s hard to determine where the risk comes in until it’s too late. Here are four rules for success in income-growth investing.
* “Keep it simple. Avoid hybrid securities, ‘option strategies’ and complicated or unusual investments of any kind. They provide no real advantage over conventional stocks and bonds.
* “Keep income needs as low as possible. If you can accept an overall yield of three per cent instead of 3.5%, you expand your choice of investments. This improves your chance of capital growth, and of benefiting from the tax advantages of capital gains.
* “Avoid ‘Reaching’ for Yield. Set your safety requirements and don’t lower them in return for higher income. The percentage point or two you get for accepting lower safety is rarely worth it, such as with asset-backed commercial paper. The yield or return you can realistically aim for depends on the general level of interest rates, which varies, of course. With interest rates so low these days, your portfolio is likely to earn less than it did before the financial crisis.
* “Make sure that each security contributes something on its own. Don’t include something merely to offset a deficiency in some other part of the portfolio. For instance, mixing high-quality bonds with stock options doesn’t give you an average-quality investment.
“What usually happens with mixes like this is that losses on the speculative section of the portfolio more than offsets the interest income on the bonds.
BUY DIVIDEND RAISERS
“Your best plan in seeking a combination of income and growth is to build a portfolio of stocks that regularly raise their dividends.
“The four rules for striking the right balance between income and growth can suit many investors for long periods of their investing careers. The most obvious users are retirees who depend little on their portfolios for income. They want their portfolios to keep up with inflation, but they can also find good uses for some extra cash from time to time.
“An income-growth portfolio may also fill a need for investors who are still five to 15 years away from retirement. It can act as a bridge between the growth-seeking portfolio of middle age, and the income needs of retirement.
“An income-growth portfolio may serve your needs regardless of age, if your earnings are erratic and you occasionally dip into your investments to meet your living expenses. So can a cash-rich Tax-Free Savings Account (or TFSA).
“I believe one of the best ways of building an income-growth portfolio is to buy shares in companies that use part of their increasing earnings to regularly raise their dividends. Since March, three of my ‘best buys’ have raised their dividends.”
Marc Johnson, CFA, Editor of The Investment Reporter, in The MoneyLetter,, 800-804-8846, April 2013