Most investors can be classed as 'growth investors'. That means they are focused on growing their investments by seeking the best return. In reality that total return is made up of growth in the capital value of their investments and the income they produce. The automatic reinvestment of that income boosts investment returns by the magic of compounding. That is, the income can be used to buy more fund units or shares which in turn can produce even more income and capital growth and so on and so on.
Yet there is a second group of investors known as 'income investors' who want to live off the income that their investments produce while the capital value of their investments hopefully grows at the same time. The trouble is that picking the right investments is incredibly difficult even if you decide to invest via funds.
The common mistakes income investors make
Income investors and financial advisers make the same mistakes when trying to build an income portfolio.
- They focus purely on current yield
- They don't analyse the actual pounds and pence funds pay as income
- They don't take into account the effect of inflation
- They don't build a portfolio that can provide a rising income into the future that can beat inflation
How to generate a sustainable income from your portfolio
For true income investors the capital value of their portfolio is secondary. In essence as long as the portfolio keeps pumping out the required income the capital value is irrelevant. So even if markets crash as long as the funds keep paying out dividends then their income and lifestyle will remain unaffected.
So the first rule of income investing is to invest in funds that will not cut their dividends. The trouble is how do you pick a fund manager who is good at picking shares that are unlikely to cut their dividends when the going gets tough?
Furthermore, if you want your income to maintain its purchasing power then it needs to grow over time in excess of inflation. So the second rule is to invest in funds that will grow the income they produce year on year. Otherwise your income will not be large enough to keep pace with the price rises of the things you like to buy. So how then do you also identify funds that will grow the income they pay out over time?
How to build the perfect income portfolio
80-20 Investor provides not only the research to help growth investors but also income investors. To empower members to quickly build a portfolio that can provide a sustainable income stream is no mean feat. It takes weeks of research, research that would cost thousands of pounds if you were even able to obtain it from another investment professional.
The UK Income Heatmap below (click the link below to download) summarises this research into a neat visual aid. The research analyses all the main UK equity income funds that aim to provide investors with an income stream. It analyses the actual pounds and pence that investors have received from these funds going back 16 years as well as how this income has grown over time. It also looks at the current yield that you can obtain from these funds and its recent annual growth rate.
It is worth mentioning that different funds pay their income at different times of the year and at different frequencies (monthly, quarterly or yearly). So in order to provide a regular monthly income stream to live off you could create a cash buffer containing at least one year's worth of income and invest the rest of your money in an income portfolio. You can then withdraw money each month from your cash buffer to live off while at the same time your income portfolio tops the pot up as and when the dividends are due. In this way at the end of 12 months your cash buffer should be of similar size as it was at the start of the year. So long as your desired income does not exceed your portfolio's yield you will be fine.
One final point to bear in mind is that you should consider diversifying your income portfolio by investing in global equity income funds, investment trusts or even alternative income producing assets. The corresponding heatmaps for these types of funds are included at the foot of this article.
How to use the UK Income Heatmap
When choosing income funds you want to choose funds that have:
- a decent current yield (anything above 5% is good)
- that have recent average annual payout growth in excess of inflation, which is typically around 2% (although not a single UK equity income fund grew its payout in 2020 as a result of the economic damage caused by the Covid-19 pandemic)
- have a track record of growing its payout year on year even when other funds have cut theirs.
You can quickly see how the Income Heatmap turns building an income portfolio from an expensive laborious process into a simple and quick job.
The Income Heatmap
Key: a blue box indicates that the annual payout was higher that year than in the previous year. A red box indicates that the payout was cut compared to the previous year. A yellow box indicates that the payout remained the same. An empty (white) box means that the fund was not in existence at that point in time.
Download the 2024 UK equity income heatmap PDF
If a fund is not on the list this will be because it either does not have a sufficient history or size. Or it will be because it is not a member of the UK Equity Income sector.
Also some of the most consistent income payers are investment trusts (the above funds are unit trusts). I have also produced an Investment trust income heatmap. Most investment trusts even managed to grow their income payouts in 2020.
In order to diversify your income you may also want to look at the Global Equity Income Heatmap and the Alternative asset income heatmaps.
