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Learn the basics of income investing and the four principles you should keep in mind.
What is income investing?
Income investing is when you aim to produce a regular and consistent cash income stream from your investments, either monthly or annually, over a period of time.
This type of investing looks to keep pace with inflation, to maintain purchasing power, in order to achieve a long-term goal, such as income in retirement, or saving for your children’s education.
Understanding an income portfolio
An income portfolio generally contains three levers: income, capital and yield.
While it’s difficult to control all three, an income portfolio prioritises consistent income and capital stability, with yield a function of the two.
A robust income portfolio tends to have investments with good income generating capability and broad capital stability.
Before building an income portfolio, an investor must first decide on the level of risk with which they find acceptable.
Higher income generally means higher risk, but at the expense of reliability, while lower risk sacrifices some income for greater stability.
A good balance can be found by choosing investments that offer attractive income, with some stability.
Four principles of income investing
Here are some things to consider when looking to invest for income:
1. Diversification is key. An income portfolio, like most investment strategies, will benefit from broad diversification across asset classes, geographies and sectors. Having multiple income streams will also help your portfolio to deliver income across different market conditions.
2. Learn about distributions. When choosing an income investment, it’s important to understand the basis for payment distributions. Does the investment have a target distribution and how is it paid? Is this level of distribution sustainable? And will your distributions be paid out of capital if markets go down?
3. Don’t forget fund performance. Regular distributions are not the same as fund performance. Your underlying capital base is the engine that drives income generation and ignoring it could mean you don’t meet your long-term investment goals.
4. Total return matters. Robust Income portfolios will have a good balance between capital stability and income growth. This will help you to maintain and grow your capital base, which also helps to increase the level of real income that you receive.
What you should remember
Income investing is not without risk, and you should always remember:
– The higher the yield, the higher the risk
Higher yielding assets tend to have more risk to compensate investors willing to risk their capital. The same rule applies for income funds, where higher distributing funds tend to take more risk with investors’ capital.
– The impact of inflation
If your income portfolio is not exposed to growth assets, its real value (i.e. after inflation) will fall over time. You can counter this by having a balance between income and growth assets in your portfolio. Income investments like inflation-linked bonds, equities, real estate and infrastructure assets can all help to generate income above inflation.
– Stay focused on performance
And finally, you should always remember, when it comes to income investments, that the yield or distributions offered is not a measure of return. Short-term distributions are only one aspect of performance, especially if they can be paid out of capital, as this could eventually lead to faltering distributions and leave you worse off.
This article is written by Fidelity International.
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