Income Investing 101

Many retirees open a bank account for dividends. Every stock they buy they do the paperwork directing the share registry to pay any dividends into that bank account. Non-retiree investors, as well as some of the wealthier retiree investors, will elect instead to have the registry use the dividend to buy more shares under the Dividend Reinvestment Plan if there is one.

For those that rely on income the formula goes like this:

Assume a 4.5% yield from the stock market – this is your justification, a factual table of the capital and dividend returns from the All Ordinaries index over the last 40 years.

As you can see the average contribution to the All Ordinaries total return from compounded dividends before franking is about 4.5% over any time period in the last 40 years. A cursory calculation of the average franking in the Australian market weighted by market cap (complex and inaccurate guess) suggests that average franking is 72%. If that’s the case then you could say that the total return on average of compounded dividends from the All Ordinaries including franking is 5.89%.

But the conservative retiree will use 4.5% because the extra 1.39% usually comes as a franking credit refund (assuming you are in a tax-free environment in retirement) and rather than rely on that they will use that lump sum once a year refund for a holiday, renovating the bathroom or buying a car. It is not part of the spending arrangement.

If you fancy learning more from our articles, like what the average return of the ASX is, check out our article here 

Assuming 4.5%, if a retiree wants to earn $100,000 a year in income from shares, they will need $2,222,222 invested in the All Ordinaries. And this is a standard income expectation, $100,000 a year. Wealthy retirees will be living off $200,000 a year. If you have enough capital to earn $200,000 a year in income without eating into the capital base, you are very well off relative to a lot of retirees.

So the game is to build a couple of million dollars, invested in the equity market, and live off $100,000 a year. A lot of the clients we see are much wealthier than that and as the wealth increases their cash holdings and investments in things like hybrids and fixed income increase. One portfolio we did this week for instance was worth $8 million with the asset allocation split a third a third a third in equities, an investment property/business, and cash equivalents – and with that level of wealth the equities were focused on growth rather than income.

But let’s take the base case of $2 million invested in equities earning 4.5%. Why in equities? Because the returns on term deposits, fixed interest and other risk-free assets is now around 1% which means you would only be earning $20,000 a year. The next best source of income is hybrids. They yield 3.5% to 4.5% with a lot less volatility than equities and that might be your choice – for more about that CLICK HERE to read our recent article in hybrids.

But for most investors hybrids have almost no chance of a capital gain and on that basis they invest in equities instead where, as you can see from the table above, you can earn another 5% (being conservative) and capital gains, in which case your capital base will not only earn your living but it will grow at the same time. This is the equities Nirvana everybody is trying to achieve and if you can start this process with a little bit of smarty-pants timing (buying after a correction) you could do a lot better in the long term.

So let’s say you have $2 million only to invest, you have decided to put it in equities, and you are looking for stocks that you don’t have to worry about, you can hold in the long-term, are pretty low risk (no Mid-Cap growth stocks), will deliver $100,000 a year into that “dividend bank account” and hopefully also deliver that 5% plus capital gain that the equity market has delivered over decades. Now the question is which stocks?

THE DIVIDEND CALENDAR

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THE MT INCOME PORTFOLIO

We also managed an income model portfolio to help show you what we think the top income stocks are.

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