The Joy of Income Portfolios - Part 2 of 5

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If you haven’t read Part 1 yet, then scroll back down my Blog Page a tiny bit and you should find it very easily from about a Week ago. It includes a list of the Parts to come and what is hopefully going to be in them (if I actually get around to writing them !!).

Features of an Income Portfolio
It’s probably easiest for me to write this as Bullets:

• Ideal Number of Stocks - I would suggest a Minimum of 12 Stocks - although obviously when you are beginning to build an Income Portfolio it will be a case of slowly Buying your Individual Positions as the Market throws Opportunities your way - I will cover this more in a later Section devoted to how to Manage an Income Portfolio. This kind of Number should give an element of Diversity across the Portfolio (I am a strong believer in the concept of Diversification to lower Risk across ANY Portfolio - this applies across any Basket of Assets - Bonds, Stocks, Property, Gold, P2P Lending, blah blah).

• Maximum Number of Stocks - A Maximum of about 20 Stocks seems instinctively correct - this will maximise Diversity and is probably a slightly safer (lower Risk) approach than just holding 12 Stocks - but in reality the difference in performance of the Portfolio in good and bad times might not be all that much. With 12 Stocks I would suggest some Sector Diversification with perhaps all 12 Stocks sitting in different Industrial Sectors - and if there are exceptions to this, it is probably unwise to have more than 2 Stocks in any one Sector or you will be massively Overweight in that area and this introduces utterly avoidable Risk (the Law of Sod dictates that if something goes wrong it will be in the Sector you are over-exposed to - the Market Gods have a right perverse sense of humour most of the time !!). Remember, Income Portfolios should be Low Risk as well as easy to manage and little effort. With 20 Stocks you can probably go up to 2 Stocks in each Sector and in extremis perhaps 3 - but that might be overdoing things. The best case / justification for holding 20 Stocks is if you have a large Portfolio in Monetary Terms.
• My Own Portfolio - I currently hold 12 Stocks in my own Income Portfolio (see my ‘Portfolios’ page for details) but I have set a maximum of 15 in my mind, unless of course I do incredibly well on the Markets and end up putting more Money into the Income Portfolio and/or it grows lots in coming years. At the moment it is relatively small but I am very tempted to add a couple of Stocks because I really think they are excellent choices and would enhance the Portfolio in many beneficial ways - I will do a lot on particular Stocks later in this Blog Series.
• Cyclical Stocks - Stocks from Businesses that are highly Cyclical might not be appropriate in an Income Portfolio - the obvious example being Housebuilders. It is a difficult one - these kinds of Stocks will suffer enormously during a Recession and not only do their Share Prices get hit (thus destroying your Capital, even if it is probably only a temporary thing and they will most likely recover after a few years), but the Dividends will most likely be cut massively as well - so this will sort of defeat the point of your Income Portfolio and if you are in the ‘Drawdown’ phase and reliant on the Dividend Stream for your Living Expenses etc., then you clearly don’t want a Cut. I guess there is a case for holding perhaps 1 or 2 Cyclical Stocks if the Dividend Yields are so massive in the Good times that they compensate for the Hit you will inevitably take in the Bad times - several Housebuilders currently pay 7% or more each Year in Dividends - this might be worth capturing but the Risks need to be fully considered. Perhaps buying a Stock in such a Sector could be a Short Term thing to take advantage of a Special Situation - but I would only suggest this is suitable for more Experienced Investors. If you have a Dividend Stream that more than covers your Living Expenses, then perhaps you are able to take on a slight bit more Risk. However, on balance, for most people I would say Cyclicals are best avoided where possible. Thinking about it, I hold HSBC Bank HSBA in my own Income Portfolio - this could be seen as a Cyclical so perhaps I need to think about that. Of course in the Credit Crush in 2008 Banks got utterly destroyed - but seeing things in a calmer way the usual Recession hits Banks but nowhere near as bad as in this particular episode of pain.
• Keep Tax minimised - It is obviously important to think about Tax implications and how to minimise this on your Income Portfolio. Keeping your Stocks within a Self-Select ISA is very effective as you can now shove in £20k per year and this is double if you can use a Partner’s Allowance as well (sorry, Dogs and Cats don‘t count, although Kids can have their own ISAs - but for them you probably want something more exciting as they have many years ahead of them so they are better placed to embrace Risk). With an ISA you will pay no Capital Gains Tax (CGT) if you ever happen to sell a Stock (this will be rare - in my own Income Portfolio I think I have only ever sold one Stock - Brit Insurance BRIT when it was taken-over). In addition, Dividends are Tax Free also - this is clearly a big advantage. If you hold your Income Portfolio within a SIPP (Self Invested Personal Pension) then the usual Pension Tax rules will apply - I won’t go into details here - if you are in this situation then I am assuming you will understand the Tax implications and/or you will speak to a Pensions Adviser. If you have an Income Portfolio outside of either an ISA or Pension (always best to use your Allowances on these Tax beneficial ‘Wrappers’ first), then you can take Dividends up to £1000 Per Year free of Income Tax and your usual CGT Allowance will. Any Dividends over £5000 would be taxed at 7.5% for Basic Rate Taxpayers, 32.5% for Higher Rate Taxpayers and 38.1% for Additional Rate Taxpayers - so you can create £5000 of Dividends without incurring Income Tax (note CGT applies) which is quite useful (I am toying with the idea of creating an Income Portfolio with igIndex because I would be able to use it as Margin (Deposit) against my Spreadbetting Portfolio - and you cannot do this within an ISA). As always, Tax Rates and stuff change quite frequently (at almost every Budget whoever is Chancellor always seems to feel the need to tinker away and alter stuff but of course the Allowances often rise with Inflation so you must always check what the situation is - either use an Adviser or have a poke around on the Internet as all that information is easily available.
• Reinvestment/Drawdown Trade-offs - As with a particular individual Stock that you choose to hold in your Income Portfolio (I will cover this in a later Section), there is a Trade-off between the Growth of your Income Portfolio in terms of its Total Value (prior to you Drawing Down on your Income Portfolio you will be reinvesting the Dividends and this helps grow the Pot) and the Dividend Return Percentage that you receive. In other words, a Portfolio that Yields 3.5% blended across the Stocks it holds, will most likely grow quite a bit faster than a Portfolio that returns perhaps 5%, which might be relatively sluggish. It is a bit of a balancing act and depends on factors such as your own personal Risk tolerance, your Income Requirements in £ Note terms, the time you have available to manage it, your interest in managing it, and the stage of Life you are at. There could well be a case for having a Lower Dividend Yield % and taking a bit higher Risk in early Years before you switch to Drawdown and then transforming the Portfolio to a Lower Risk but higher Dividend Yield collection of Stocks when you are older and in Drawdown mode. This has got me thinking because I currently am targeting 5% Dividend Yield on my own Income Portfolio but I am not yet in Drawdown Mode and probably won’t be for many years - perhaps I need a rethink !! Having said that, my Low Risk approach is increasing my Overall Wealth Diversification as I take much higher Risk in my usual Share Investing and my Income Portfolio needs minimal maintenance - perhaps a lower Yielding Portfolio would be more demanding to manage. In fact, I would not be surprised if my ‘Trading ISA Portfolio’ actually has a Dividend Yield around 3% to 3.5% - I have never bothered to actually work it out. If I am going to recreate my Income Portfolio for use as Margin needs for a Spreadbet Account, then it makes sense that I hold quite different Stocks in it from my Trading ISA (and it makes sense to have different Stocks as Spreadbet Positions) and that it is Low Risk and Low Maintenance.

Managing an Income Portfolio
This aspect is very important and it is worth creating your own set of ‘Rules’ that codify exactly how you will manage your Portfolio - I will put a Link at the End of this Blog Series to an Example of the ‘Rules Template’ I use myself and I will also include it at the bottom of this one. Here are some steers:

• Plan your Holdings - When starting the Income Portfolio, I would suggest spending time to carefully plan what Stocks you are going to Hold and it is a good idea to write down somewhere a set of Target Prices at which you would like to Buy a particular Stock - obviously if a Share falls in Price then its Dividend Yield rises (I explained this in Part 1 of this Blog Series) and although it is probably not a good idea to buy a Stock that has just put out a Profit Warning and is in trouble, Stocks can regularly move down for no particular reason and it is these kinds of wobbles that you want to take advantage of if your Target Price becomes available to you. I always giggle at the ‘Efficient Market Hypothesis’ nonsense which claims that a Share Price always reflects the true value of a Stock at a given time and “the Market is always right” - what a load of bilge. The way I see it “the Market is always wrong” and Prices move in ‘Waves’ over time and we need to take advantage of these patterns.
• DRIP Schemes - I know a lot of People use Dividend Reinvestment Plans (DRIP) but personally I hate these and think they are a bad idea. OK, from a doing nothing point of view I can see a bit of appeal but the downsides by far outweigh this. With a DRIP Scheme, the Company lets you take Dividends as more Shares in the Company rather than as Cash - this means that you could be paying high prices in effect for your New Shares and it could mean that a particular Position becomes very overweight if you do the DRIP scheme for many years. I also resent these Schemes because I think they are a ruse to help support the Share Price and this in particular helps Directors whose ridiculously High and Greedy Bonus payments are often dependent on a high Share Price !! I think it is far better to let the Dividends from your Individual Stocks to steadily flow into your Account and to build up your Cash Pile and then once you have a decent amount, you use the Cash to Top-up a Position you already hold or perhaps you spread the Cash over a few - it is up to you. I have a rule where I have a Minimum Deal Size (probably something like 4%/5% of the Portfolio Value) - at the moment for my Income Portfolio it is about £2300 but I raise it as the Portfolio grows. So once I have £2300 built up within my iWeb ISA Account, I start thinking carefully about which Stock I will buy more of but as I want to increase my Number of Stocks, I might buy a New Stock once I have the Cash ready (at the time of writing I am very keen on Vodafone VOD). Obviously I will wait until the Market offers me my chosen Buy Target price.
• A good reason to Sell a Stock - As a general rule it makes sense to not Sell Stocks very often - however, once you are in Drawdown Mode, it might be forced upon you because if a Stock rises in Price a lot, you might find that the Dividend Yield drops to such a level that it is not generating enough of an Income Stream for your own Spending Requirements. For example, if one of your Shares rises so that the Dividend Yield drops to about 3%, you might decide that you should sell it and replace it with another Stock that gives you 5% or something - it is not an easy decision but whatever you do, it must never be a rushed decision. As with all things to do with Stocks, I find that if I am rushing a decision and doing something in a knee-jerk fashion, then I am probably about to commit a huge error that will bite me in the Gluteus Maximus later (that‘s your Rump my dear). If one of your Stocks has some Business Problems (no doubt it will issue a Profit Warning) you need to think very carefully about how to deal with it. Could it be that the problems are of a temporary nature and the Dividend can be maintained (or maybe cut a bit - this happened to me on Sainsburys SBRY but I am still holding it as I think it is a pretty reliable Stock and the Dividend is rising again), or is the Company in proper trouble and at risk of going Bust or something? If you think there are really serious and existential problems, then it is probably wise to Sell what is left of your Position and to buy something else. This is not a good situation and it is something we want to avoid as much as possible, and it is why careful Selection of your Stocks is vital. You cannot however avoid these sorts of problems and you will almost inevitably get some issues along the way - but if you have decent Diversification your other Stocks should help offset any hits you take.
• Stoplosses - I don’t see using a Stoploss as appropriate for an Income Portfolio (in fact, for Long Term Investors, I don’t think Stoplosses make any sense at all) and rather than using such a technique, if a Share Price falls a lot, this should be viewed as an Opportunity to buy more Stock and ‘Average Down’. However, care is needed, it can be extremely dangerous to Average Down on a Stock that has fallen because it has problems - especially if it is going to go bust because you will merely be compounding your Losses. However, if a Share has dropped as just the usual ebb and flow of the Markets, this could be a great Opportunity to buy more of a Stock and to get a higher Dividend Yield from it - so it is clearly illogical to use Stoplosses. I have put a Link to a blog I did on ‘Averaging Down’ at the bottom of this blog.
• Rebalancing - If you let a particular Stock or a couple of them get heavily Overweight in your Portfolio, then you start to lose some of the Benefits of Diversification. As an example, you might hold 12 Stocks and think you have a nicely spread out Portfolio, but if one of your Stocks makes up, say, 25% in Value Terms, then in fact your Portfolio will behave much more like a Portfolio with perhaps as few as 6 Stocks - so your Risk overall massively rises. For this reason, it is important to keep an eye on the Values in each Stock in your Portfolio and to ‘Rebalance’ from time to time so that you avoid the Overweight problem. This can be done by simply re-investing Dividends or Cash from the occasional Sale of a Position or part of a Position (or perhaps fresh Cash put into the Portfolio), into the Stocks which you have smaller Positions in and if the worse comes to the worse, you could perhaps slice the Overweight Stock and use the Cash to top up on others. These kinds of imbalances can occur simply over time as some Stocks rise a lot and others fall - so it is important to monitor this. There is no need to rush to rebalance - in fact, I would say that with Investing/Trading in general, you are probably making a huge error if you are rushing to do any Trades. Take your time and think carefully before acting and make sure you are topping up on the most deserving Stocks and ensuring the Low Risk stance of your Income Portfolio is maintained. If you have a particular Target Dividend Yield, you will need to ensure that any Rebalancing is in line with your desired Dividend level.

What happens when the Markets Crash?
Without doubt when the Market throws up a proper Bear Market (like in 2003 and 2008) this can be a difficult time for Investors’ emotions and in many ways it really is about keeping our nerve and trying to stay rational and mindful of the Bigger Picture.

Over time there have been many Bear Markets of varying degrees, I think from memory these tend to be fairly quick events and usually they are all done and dusted inside 1.5 years and the Markets soon recover their footing and start rising again. It is often said that if you look back at the Index Charts such as the FTSE100 and S&P500 in the US over perhaps 15 years, the most severe Bear Markets such as that in 2008 barely show on the Chart as a bit of a dip.

When you look back to 2008 and think about what has happened since, it is clear that all Major Stockmarkets have recovered and gone much higher and in that time they have paid huge and growing Dividend Payments which are such an important part of Total Returns (and are relatively easy to obtain - I see it as ‘Free Money‘ !!).

In reality, Bear Markets are actually a fantastic opportunity for Income Investors to buy outstanding Dividend Stocks at really attractive Prices and therefore consequently very High Yields - which is of course the key objective of our Income Portfolios. Without doubt it is not easy to buy at such times due to your Fear emotions but if you can stay rational and focus on the Long Term, then when you see a Stock with a really attractive Dividend that would complement your Income Portfolio’s Diversification then it might be worth snapping it up. Equally, you might want to buy more of Stocks you already hold if their Share Prices get really beaten up. Remember, as an Income Investor you are interested in the Dividend Income that your Portfolio generates and you should keep your mind focused on this. As long as the Cash keeps coming into your Account in the form of the Dividend Payments, then you can stay fairly emotionally detached and just ignore the fluctuations in the value of the Capital in your Stocks. In time they will recover.

Of course if you are very experienced and able to take an active stance, then you might be able to Sell some Stock early on and to move into a larger Cash Position in the hope that you can buy more Stocks (possibly just buying back the Stocks you had) much lower down - however, this has lots of Risk and such timing is extremely difficult - so for most people (especially the Inexperienced) it might just be best to sit tight. If you have Cash from other Sources that you have not put into your Portfolio (possibly from Employment or other Trading Activities etc.), then such a Bear Market is utterly a Godsend for you because you will be very well placed to exploit it and buy some proper Bargains.

If you are in the fortunate situation where you do not need the Dividend Payments for your Living Expenses, then you can let the Dividend Payments build up in the Cash Pile in your Account and when there are such Drops in the Markets you can deploy some or all of this Cash to buy Stocks cheap. Equally, even if you do use some of the Cash for your Living needs, if you have some left over that can obviously be re-invested to take advantage of Bargain Shares. For example, if your Portfolio has an Overall Yield of 5%, but you only take 3% out of it for your Living Expenses each year, then you will be retaining 2% Annually which you can reinvest into the Portfolio Stocks to help generate more Returns in the future. 

I realise now that I should have mentioned this before because it is very important - but I would suggest that if you have an Income Portfolio producing 5% a Year it is best if you can to take out less than that once you are in Drawdown Mode - for example, taking out 4% or 3.5% etc. would mean you retain some Dividend Cash for Reinvestment which helps to ensure the Value of your Portfolio can continue to grow at a reasonable clip.

That’s it for Part 2, if the winds blow our way I should have Part 3 ready for next week,

Regards, WD.


Related Blog Links:
Here is the Rules/Parameters Template Blog - note it is considerably more complicated than what is really needed for an Income Portfolio but it is a Blog I wrote years ago and I suspect many newer Readers will not have suffered it before:

http://wheeliedealer.weebly.com/blog/yearly-trading-rules-parameters-template

Here is the Averaging Down blog:

http://wheeliedealer.weebly.com/blog/is-averaging-down-the-root-of-all-evil