The Motley Fool

What You Need To Know About Income Investing

There are a few different investing styles that investors can adopt, and each has its own advantages and disadvantages. However, the most important thing for us to do as an investor is to pick one that we feel most comfortable with. That’s how we can sleep soundly at night.

The few investing styles I am referring to are: income investing, growth investing, and value investing. In this article, I will be focusing on income investing. For more on growth investing, head here.

Income investing – as the name suggests – entails investors prioritizing the income generated from their investments over capital appreciation. This can be done in a few ways such as buying stocks with high dividend yield or investing in bonds.

The latter option is relatively safer, but has lower chance of capital appreciation. This is because the company or entity (bonds can be issued by governments too!) that issues the bond is obligated to pay interest at stipulated time periods, and to return the invested-capital to the investor after a stipulated time. Capital appreciation can occur with bonds if they are bought at a price lower than what they are issued at, or if interest rates start rising.

Stocks with high dividend yields are a relatively risker option. This is because stocks do not come with any contractual-obligations on the part of the company to make any dividend payment to its investors.

A company may pay a dividend every three months, six months, or every 12 months. But, the amount is entirely up to the discretion of a company’s management. Sensible managers of companies though, tend to pay a dividend that is commensurate with the health of the companies’ underlying businesses. This also means that a company’s dividend can be subject to fluctuations, depending on the performance of the company’s business. Some examples of high-yielding stocks in Singapore’s market would be REITs (real estate investment trusts) or telecommunication companies.

Income investing is usually popular with investors who need to generate a certain amount of income from their investment portfolio to fund expenses. For example, retired individuals usually prefer income investing as the income generated can be used to support their lifestyle. That is not to say that income investing is not suitable for the younger generation. At the end of the day, it’s an investing style that can suit any individual’s personal preference.

If you’re investing for income, there’s a mistake to look out for, and that is, the high-yield trap.

Getting snared by the high-yield trap can occur if you’re investing in stocks only because they have high dividend yields. Thing is, certain stocks may have high yields because their businesses are in trouble, which could result in lower dividends over time. There are a number of things to look out for in a stock so that we can minimise – but not completely eliminate – the chances of us falling into a high-yield trap.

Firstly, we should analyze a company’s dividend history, going back at least a few years. What we need to see is if the company has been consistent in terms of paying a dividend.

Secondly, we could also examine the payout ratio of a stock. The payout ratio is expressed as a stock’s dividend divided by its earnings per share. Generally, a payout ratio that is close to or over 100% is a red flag – it’s hard for a company to continue paying a dividend that’s higher than what it’s earning. A good range would be for a company to payout between 50% and 75% of its earnings.

Thirdly, we could look at the balance sheet of a company. A company that has too much debt is putting its dividend at risk. A good rule of thumb to sieve out a healthy balance sheet is to look for a company with debt that is less than 100% of its equity.

Having looked at incoming investing, stay tuned over the next few days for a primer on value investing.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.