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Income Investing
An Intelligent Approach to Profiting from Bonds, Stocks, and Money Markets
By JASON BRADY The McGraw-Hill Companies, Inc.
Copyright © 2012Jason Brady
All rights reserved.
ISBN: 978-0-07-179111-3
Excerpt
CHAPTER 1
INVESTING FOR INCOME
"Amen!" cried Goodman Brown. "Say thy prayers, dear Faith, and go to bed at dusk, and no harm will come to thee."
—Nathaniel Hawthorne, "Young Goodman Brown"
If you've picked up a book about investing for income, I probably don't have to convince you that it's an important strategy or that income generation is likely to be a key part of investment returns for the foreseeable future. But coaxing income from your investment portfolio is easier said than done. There are a number of serious pitfalls and issues involved in any income strategy, and we'll explore them in depth as this book goes on.
Investing for income is not a new concept. John D. Rockefeller, famous philanthropist and founder of Standard Oil, reportedly said, "Do you know the only thing that gives me pleasure? It's to see my dividends coming in." But investors do not need to be ultra-rich or even moderately wealthy to look toward their nest egg for income. Often this strategy is the basis behind retirement planning for all sorts of individuals and institutions. Endowments and foundations are designed to withdraw a certain percentage of their principal every year in order to meet their objectives, making an income strategy a perfect fit. Baby boomers are reaching the disbursement stage, or the stage at which they are no longer collecting wealth but using it, and as a result, the $17 trillion of investable assets in U.S. households will likely begin to skew toward income-producing assets and strategies.
SLOW, BUT STEADY
Market talking heads are typically interested only in what prices did today. I was invited to be on a particular financial news network a little while back and was asked what the "smart money" was buying "today." This is not the way to invest for income, or likely a successful way for most people to invest toward any goal.
At the end of 2011, something remarkable happened. The S&P 500's price was almost exactly the same at the end of the year as the beginning (down 4/100 of a point or .004 percent). News outlets everywhere reported that the S&P 500's return was zero for the year. "Virtually unchanged for the year," said Bloomberg News. But in fact, the total return on the index was 2.11 percent, because the S&P 500 pays a dividend (albeit a somewhat paltry one). Investors everywhere are quick to check the price return of all of their investments and forget the income that rolls in, unheralded, over the course of a longer investment time horizon.
With the greater availability of information these days, many investors check their account balances or the prices of what they own on a daily basis. Their mood is good or bad that day based on what direction those holdings went. Principally, investors are long on stocks, and therefore, when speaking with groups of investors, I can be fairly certain that they will be happy or sad based on the presence of green or red on the ticker running on the TV. Even if some people have a longer-term investment horizon (which, these days, means more than a year), they still are focused on price movements. Income is old fashioned and slow moving. If I own a stock that generates a 4 percent yield, that yield is likely going to be grossly overshadowed by the price movement of the stock over shorter periods of time. If people look at the stock price every day, it's easy to forget the dividend payment that comes along every quarter. But when that day comes, I'll receive my 1 percent. Of course, because the market incorporates that dividend payment into the price, it's likely that most investors will only notice the payment because the price of the stock went down by 1 percent that day. So it's very unsatisfying to an investor who is focused on returns on a day-to-day basis. Bonds are even worse in this regard, as prices are, for most fixed-income investments, more staid compared with the flashing red and green lights of stocks. And even when there is movement, the price of a bond is much less observable, making it much harder to celebrate winners or ignore losers.
Here's a quick thought experiment: Would you rather have a 5 percent yield for five years, or a series of returns that are: up 12 percent, up 10 percent, down 30 percent, up 35 percent, up 5 percent? Many people, at least when the whole series is presented, choose the latter. Though you have a 30 percent drawdown, it's mitigated by the up 35 percent the next year, and there are four winning years out of five. In fact, a 5 percent yield for five years is a 27.6 percent return. The irregular series of returns listed above is a 22.2 percent return. A significant difference, and with the irregular series you also had to deal with the heartache due to volatility and almost certainly the thought process of being in the market for the long run came up against some real angst.
Investing for income is a slow, steady race: a marathon, not a sprint. Though it's certainly exposed to market volatility, that stock that pays 4 percent in effect has a 4 percent tailwind. The bond fund that returns 5 percent, mainly through income gains, may not make fantastic gains in a stock bull market, but 5 percent compounded is pretty attractive. And that's the key: even if investors have a long time horizon, it's difficult for most people to think about compounding returns, geometric returns versus additive arithmetic ones. This is an advantage for investors who are willing to look past the daily ups and downs of the market and find true long-term returns. The investors who are supposedly in the market "for the long run" are often nevertheless scared away from the market just when they should be invested. It's hard to avoid that psychology. Because of the short-termism prevalent in investing today, the tortoise-like returns due to income get ignored by even conscientious, thoughtful market participants. If you look at your investments every day, the income doesn't show up. Even every quarter, that income can be negligible (especially in today's low interest rate environment). But year in and year out, compounding income can be pretty interesting.
YIELD AND INVESTOR PSYCHOLOGY
Buying a bond or a dividend-paying stock for income is not the simple activity that it seems. Perhaps the act of buying the security itself is getting simpler, with significant advances in technology, but the various outcomes that can come from that activity are complex and fraught with potential ugliness.
A key to successful investment for income is to recognize what pitfalls are inherent in trying to coax a reliable income stream from an unreliable market. Investors (who are no different from any other type of person) are typically overconfident in their ability to anticipate all possible outcomes in a certain situation. Furthermore, the promise of a certain yield fixes the idea of that return in an investor's mind. Psychologists call this anchoring.
Amos Tversky and Daniel Kahneman, two pioneering researchers into cognitive biases, asked two groups of people to guess what percentage of African nations were in the United Nations. To the first group, they first asked if the number was more or less than 45 percent. To the second they first asked if it was more or less than 65 percent. The first group guessed a far lower percentage than the second, as they had been conditioned by the "anchor" of the suggested percentage from the previous question.
The biggest problem in investing for income arises from the expectations of all of us as investors. Too many times people buy a security and believe that the quoted yield or expected income is something to bank on as a total return. Largely, that is not the case; yield is a bad measure of the pote
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Excerpted from Income Investing by JASON BRADY. Copyright © 2012 by Jason Brady. Excerpted by permission of The McGraw-Hill Companies, Inc..
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