Reasons to invest for income

Reasons to invest for income

As Nigerians continue to rack their brains on how best to outlive recession and happily live ever after, financial experts have warned that “anyone still in cash should really consider taking on a little more risk to get better returns”. They reasoned that apart from better savings account, there’s no magical way of earning more interest: a higher income means taking on greater risk.

An online platform, marketviews.com itemises 10 reasons an investment savvy individual should invest for income. Here are some of them:

Greater risk means greater reward

Justin Modray, founder of Candid Financial Advice, a recently-launched independent financial adviser (IFA), warns that, aside from shopping around for a better savings account, there’s no magical way of earning more interest: a higher income means taking on greater risk.

“If you can’t afford to lose money, then taking risk is probably a bad idea, but if you can afford to risk some money, or already have a portfolio of investments, then other sources of income stack up well against cash.”

Capital protection

This doesn’t mean to say that, by stepping up the risk scale, you could end up losing your shirt: protecting capital is an essential part of any fund manager’s role.

However, equity income managers tend to be more cautious in their choice of stocks, typically looking for those that will provide steady capital growth rather than stellar returns.

Defensive stock

A defensive stock is one that provides relatively constant dividends and stable earnings regardless of the state of the overall stock market or wider economy. For example, blue chip pharmaceutical and consumer goods are often described as defensive in nature, because people don’t stop needing life-saving drugs or consumer goods. That means these companies aren’t likely to suffer a huge drop in earnings – and will still have cash to hand back to shareholders.

Lower volatility

While income funds might not shoot the lights out, income-based investing can act as a prop to performance when equity markets are in the doldrums or experiencing huge swings in volatility. That’s because many high-yielding stocks – the type that income fund managers tend to hold – are defensive in their nature. A company paying a good and rising dividend often communicates strong financial well being, since dividends ultimately come from earnings and profits. And they are less likely to be dumped wholesale in difficult markets, because the income helps to compensate investors for any loss of capital value. In short, income investing produces an overall total return that is less volatile than the equity market as a whole.

Power of compounding

No other investment has endured quite like equity income. The attractions of equity income remain the same today as they have always done, a key one being the power of compounding. Income investing exploits the benefits of compounding – the earning of returns on returns already made.

Dividend growth

Dividend growth over the years is vital for income-seeking investors, particularly those facing a long and hopefully fruitful retirement, and many income funds are focused on growing dividends.

Investment discipline

As companies with strong financial wellbeing attract investment, the price goes up and the dividend yield comes down. At this stage, an equity income manager will often sell, looking to reinvest in the next high-yielding opportunity. Equity income managers’ strategy therefore causes them to buy shares when they are cheap and sell when they are expensive – one of the cornerstones of successful investing.

Capital growth

It is equally important to grow capital where possible. Many income fund managers aim to identify value in areas other investors have overlooked – another key driver of performance.

Again, some income fund managers are focusing their attentions on medium sized and smaller companies. Historically, such companies were expected to reinvest profits in the business rather than paying them out to shareholders, but canny managers are finding valuable income opportunities among these smaller, faster-growing enterprises.

Cyclical stock

A cyclical stock is one that is sensitive to business cycles and whose performance is strongly tied to the overall economy. Cyclical companies tend to make products or provide services that are lower in demand during economic downturns and higher in demand when the economy is buoyant. Examples include car manufacturers, retailers and house-builders.

savings account just to stand still. If you are a 40% taxpayer, you’d need a 3.33% return, and if you’re a 45% taxpayer you would need to earn 3.64% on your cash for it to keep pace with inflation.

Some investments, such as index-linked gilts, promise to beat inflation, albeit not by much.

As dividend-paying shares often offer a growing income plus the potential for capital growth, they can boost your chances of netting an inflation-beating return. In the last three years the average fund in the equity income sector has grown 38.21%- more than six times the rate of RPI inflation of 5.7% over the same period, figures from Chelsea Financial Services show.the black market rate 391.