Income Investing can be defined in a number of ways; I think of it though as investing with dividends absolutely front and centre of mind. I believe a focus on income is essential for any investor who wants to sustainably grow a portfolio.
It is well documented that compound investing is a brilliant way to grow wealth, it is an idea heavily endorsed by none other than Albert Einstein, he once called compound interest “the greatest mathematical discovery of all time”.
What is it?
Compound investing is achieved when you invest money and you earn interest on your capital, when buying shares this comes from dividend payments. The next year you earn interest on both your original capital and the interest (reinvested dividends) from the first year. In the third year, you earn interest on your capital and the first two years’ interest/dividends. It’s all about earning “interest” on your interest. That is the phenomenon of compounding.
Compound investing could be described as a snowball effect. As your capital grows year on year and the dividends rack up, the overall snowball becomes bigger and bigger. Even if you start with a small snowball, given enough time, you can end up with an extremely large snowball that can continue to grow; as long as dividends are reinvested.
Why it’s good for investors
The benefits of compound investing underpin the attractions of income investing for me. Dividends play a vital role in creating wealth from investing in shares and therefore to focus time and research into selecting companies with high, sustainable dividends, seems to me like a very sound investment strategy. Income investing needn’t replace a focus on growth, or a mindset which has growth as an objective. Good income investments should themselves achieve high rates of capital growth, even if not all the time, as companies and sectors go in and out of favour.
As with all investing, timing is important. To reduce the risk, I’d suggest investing each month, so that the risk of investing when a share price has peaked is reduced. This is especially important during bull markets when prices can become inflated, making the downside greater when markets fall.
Overall, shares that pay out high dividend yields can be great investments and help investors to benefit from compound investing. If the dividends are sustainable and growing, then the share price should in most cases rise over the medium to long term. The danger is, some companies with very high dividend yields will find their dividend payments too burdensome and must cut them, this usually results in serious share price falls, which then hurt investor returns. It’s trap investors need to be aware of.
I don’t think though that this makes income investing too risky, indeed other strategies carry their own risks, that is part of investing in the stock market. Investors need to take steps to maximise returns and reduce their risk, for example, by diversifying their portfolio and holding cash.
I know I’ll continue to invest for income and that companies with high, sustainable dividends will always form a core part of my investment portfolio.