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The comforting allure of income investing

Gather together a group of novice investors and building society savers, and then ask them what puts them off investing in shares.

The answer: risk. Specifically, the risk of loss of capital. The returns available from bank accounts and building societies aren’t particularly stellar, you’ll be told, but at least you won’t make a loss.

In fact, they couldn’t be more wrong. In today’s era of low interest rates, savers almost certainly will make a loss. The return available on most accounts is lower than the rate of inflation, meaning that real inflation-adjusted returns are negative.

In contrast, should a share price temporarily dip below what you paid for it, it’s just a paper loss, affecting only forced sellers. Long-term investors, who don’t have to sell their shares, can just sit out a short-term fall.

And a glance at any chart showing stock market movements over a long period will quickly confirm how temporary most share price falls usually are.

Postponed profits

Even so, nervous savers have another option open to them, if they’re comfortable thinking long term. Namely, a diversified portfolio of income-focused shares, where investors receive quarterly or twice-yearly dividend payments.

And the charms of income-focused shares are best appreciated by comparing them with their exact opposites, namely growth stocks.

As the name implies, pure-bred growth stocks are exactly that: they pay minuscule dividends, if any, so as to reinvest the maximum cash back into the business. Investors receive their return only when they sell the shares, and bank the profits. Until then, any gains, as reflected in a rising share price, are simply paper profits.

And as a long-term investor, I’ve always found investing in growth stocks to be a frustrating affair. I invest time and money in researching and getting close to a successful business but can only profit by selling my stake.

Tasty dividends

With income-focused stocks, there’s still an element of capital growth and rising share prices. Albeit at a slower pace, usually.

But crucially, such stocks also pay dividends. And those dividends can equate to a tasty yield. In terms of my own portfolio, for instance, I generally look for an above-average yield ideally in the 4–5% range.

Not too high a yield, as that can indicate market nervousness regarding dividend sustainability or a business’s long-term prospects. But reasonably above the market average of 3.5% or so.

Right now, for instance, there are plenty of decent, well-managed, solid income stocks offering that sort of yield. A good number of which, of course, I have stuffed into my portfolio, generating an attractive income.

Here are some examples of the historical yields currently on offer:

And so on, and so on.

Dividend-paying defensives

Now, such shares do have one drawback: as cash cows, they are growing only slowly. Which means that dividends are also growing slowly. Indeed, some of the companies above have frozen their dividends at present.

So, an investor who wants a rising income will need to blend such companies with lower-yielding shares where dividend growth is still very much a prospect.

That said, higher-yielding income stocks do have one very useful property should a market correction occur: in general, they are seen as defensive ‘safe havens’, and so their share prices tend to fall by less than the market average.

So nervous investors need not be quite as nervous as they otherwise might be.

5%, or 0.5%?

My guess is that many novice investors and die-hard building society savers will have been surprised at the yields that I quoted above.

5% or even higher? From long-established High Street stalwarts? Plus the prospect of rising share prices, over the long term?

And, even better, quarterly dividend payouts, in many cases.

At a time when many savings accounts offer miserly rates of interests and just one annual interest payment, the potential returns from stock market investing have an obvious allure.

And with interest rates still at rock-bottom levels, ten years after plunging to 0.5% in the wake of the worst recession since the 1930s, that allure is undiminished.

Buy-And-Hold Investing

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Malcolm owns shares in Royal Dutch Shell, HSBC, GlaxoSmithKline, BHP Billiton, Legal & General, Royal Mail, and Phoenix Group. The Motley Fool has recommended HSBC and owns shares in GlaxoSmithKline.