Investors, particularly retirees, seeking income from their investments have been cautioned to be aware of fake income.
Plato Investment Management managing director Don Hamson said real income is that derived from investments in the form of interest, dividends – including franking credits – and rents.
“It should not include realised capital gains as these amount to capital returns, not income returns,” Hamson said today.
“Some of today’s investment opportunities blur the income/capital definition.
“For example, term annuity income payments usually reflect both income and return on capital.
“Similarly, the income distributed from managed funds may represent a combination of real income – interest, dividend and rents – and realised capital gains from an increase in stock prices.”
He added investors need to tread carefully around investments that pay out high levels of ‘income’ at the expense of a declining capital value.
Income-focused equity investors should seek to grow their capital base while generating that income, he said.
“Income can be derived with a similar, or even less than, market level of risk,” he noted.
“Higher-yield stocks may actually be less risky than low or zero-yield stocks, to the extent that small, risky growth companies often pay very low dividends, if any, whereas what are considered safe and mature companies, such as the Australian banks, may pay handsome levels of income.
“We also note that high historical dividend yields, caused by falling share prices, could suggest poor prospects for that company and a high likelihood of dividends being cut in the near future.”
At Plato, stocks that are likely to cut dividends are proactively avoided and known as ‘dividend traps’, he said.
Further, income should also be real in the sense that it is adjusted for inflation, he noted.
For example, the current official overnight cash rate is 1.5 per cent a year in nominal or pre-inflation terms, but after allowing for the current 1.9 per cent consumer price index inflation rate, overnight cash is actually earning a negative real rate return of -0.4 per cent a year.
“Income investors need to be aware of these fake income traps if they are seeking increased income from their portfolios,” Hamson said.
A Plato survey from 2017 found 29 per cent of respondents sought income greater than 7 per cent from their portfolios, closely followed by 21 per cent of respondents expecting 6 per cent to 7 per cent, and 29 per cent expecting a 5 per cent to 6 per cent return.
“These levels can’t be generated by fixed income or typical low bank term deposits,” Hamson warned.
“Meeting these expectations requires equity dividends combined with a smart and sustainable investment strategy.”
