The Role Stocks Play in an Income Investor’s Portfolio

Fixed-IncomeIn my recent article, “Income Investing – What Exactly Is It?” I noted that income investing “involves focusing your efforts on creating diversified streams of income with as little risk to principal as you feel is possible in order to sustain your purchasing power over time.” I am a big fan of creating income streams not just by diversifying within one asset class, but by purchasing securities across a variety of asset classes and asset class categories. One such example is by purchasing stocks, specifically common stocks.

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Individual Common Stocks

There should be well-thought-out reasons for why each and every security deserves a place in your portfolio. Regarding individual common stocks, the primary reason I own them is for the potential dividend growth. A secondary reason is for the potential capital appreciation. I like to think of companies that have a history of raising dividends on a regular basis as providing an income stream similar to that of a variable-rate bond—except the rate, in many cases, rarely goes down. Notice that I didn’t say I view my dividend stocks as bond replacements. I know that calling certain dividend-paying equities “bond replacements” became popular in the financial community in recent years. But common stocks carry risks that in my opinion do not make them suitable bond replacements. If you believe you should have X amount allocated to bonds, then X amount should be allocated to bonds, not “bond replacements.”

Why exactly does dividend growth provide an income stream similar to a variable-rate bond? This is because with each successive dividend increase, the investor’s yield on cost increases. If you purchased XYZ stock for $50 per share, and, at the time of purchase, XYZ was paying a $1.50 annual dividend, your yield on cost and the stock’s dividend yield would be the same, 3%. Fast forward 10 years, and XYZ is paying a $2.50 annual dividend. The $2.50 dividend means your yield on cost (your cost is $50 per share) grew from 3% to 5%. Let’s jump another 15 years into the future, and XYZ is paying $6 per share in annual dividends. Over the course of 25 years, your yield on cost would have grown from 3% to 12%. Of course, things don’t always work out that way. And it is the risk of things not working that needs to be carefully managed within an income-focused portfolio.

A secondary benefit to owning individual common stocks in an income-focused portfolio is capital appreciation. To guard against the risk of potential future inflation, it is necessary to have a component of the portfolio that should benefit over time from rising prices. But it is also necessary to not forget that capital appreciation is a secondary concern. Should you get too aggressive in your stock selections, it could harm your portfolio. When managing my allocation to individual common stocks as part of my income-focused portfolio (distinct from my trading portfolio), I do my best to ensure that one or more of the following three things do not occur: (1) the portfolio is overly exposed to equities, creating the risk of the next bear market causing me significant hardship/changes to my standard of living, (2) one or more of my individual stock selections goes terribly wrong, offsetting the benefits to my portfolio provided by the other individual stocks, and (3) my allocation to stocks underperforms the broader stock market indices over extended periods of time.

Notice that in (3), I stated “my allocation to stocks,” rather than “my allocation to individual stocks.” I own stocks in order to capture dividend growth and as one method of helping to maintain the purchasing power of my investments. And in case the allocation to individual stocks provides sufficient dividend growth but underperforms broader-market indices, I also have an allocation to equity index funds. The primary purpose of also allocating money to broader-market indices is to ensure that the correlation between my equity portfolio and the broader-market remains no lower than a minimum acceptable level.

Equity Funds

As I stated above, the primary purpose of investing in equity indices within my income-focused portfolio is to maintain certain minimum correlations with the broader market. If one of the reasons I am investing in stocks is to protect my purchasing power, then I want to make sure that at least some of my equity portfolio is guaranteed to be correlated with broader-market indices. And the way to do that is to purchase equity funds that track broad-market indices. Furthermore, when purchasing equity funds, pay careful attention to all the fees and costs associated with those funds. Fees can vary greatly across different funds and fund families.

Additionally, I would like to point out that investors can also realize rising yields on cost when investing in equity funds over extended periods of time. But given the extremely unimpressive yields that most broad-market equity indices currently offer, it will take a while for your yield on cost to reach levels that many income-focused investors would consider exciting.

Conclusion

Individual common stocks and equity funds have a role to play in the income-focused investor’s portfolio because of the potential for dividend growth and capital appreciation to protect purchasing power over time. But investors should remember that common stocks are at the bottom of the capital structure for a reason. An investment in common stocks carries certain risks (and rewards) that other parts of the capital structure do not carry. While it has been historically true that stocks outperform other asset classes over very long periods of time, it is important to remember that each of us has very defined time horizons. Each of us runs the risk of growing old at an unfortunate time in stock market history. How much you are willing to risk that your time horizon won’t correspond with an unfortunate time in stock market history will help shape your allocation to stocks within your income-focused portfolio.

In the next article, I will examine the role that traditional bonds can play in the income investor’s portfolio.

More from The Financial Lexicon:

Income Investing Insider Newsletter
The 5 Fundamentals of Building a Retirement Portfolio
Options Strategies Every Investor Should Know

 

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