HYP

Back in September 2007, I concluded a series on how to roll your own income generating high-yield portfolio (HYP) of leading UK shares with an article that put together an example portfolio.

I’ve not tracked that portfolio’s performance, but I’m sure its value has fallen; we’ve been in a bear market, and high-yield dividend payers have suffered at least as much as any other shares. (The paid-for equivalent, the equity income funds, have certainly slumped.)

I’m not too bothered by that September HYP’s decline, however, for five reasons:

• Short timescale: Six months is a ridiculously short-term in which to judge a share portfolio’s performance - come back in five years, or better ten.
• Volatility in inevitable: There are no guarantees in stock market investing - shares can, famously, go up and down. This happen however and whenever you invest. If you’re risk averse but want market exposure, consider drip-feeding in your money, which will likely reduce your overall returns but will at least avoid you putting money in at exactly the wrong time.
• HYPs are all about income: So far as I know, none of the 20 shares I put into my example portfolio have cut their dividends.
• I don’t give advice: Please read my disclaimer.
• Many blue chips are now cheap: It looks a great time to top-up the HYP.

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The Dividend Growth Investor blog has an interesting post about long-term dividend investing. His rule of thumb is that a dollar saved in your twenties will provide a dollar a year in your sixties:

I found that the average time it took a $1,000 investment to produce $1,000 in dividend income for a full year was 35 years. In other words if you contributed $1,000 towards your retirement by investing in a broadly diversified stock index fund when you are 23 in 2008, you would expect to achieve $1,000 in dividend income on average by the age of 58.

The chart below shows that the longest period to achieve the desired dividend income was 45 years, for those who started in 1928. The shortest it took to achieve $1,000 in dividend income from a $1,000 investment was only 27 years for those who started in 1941.

On a less positive note, the writer points out that US dividend investors have had to wait longer every year for their dollar return payout, due to decreasing dividend yields.

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Most of us get into investing because we want freedom, whether from office bores, traffic jams or the drudgery of a mortgage. We want to be free from having to work for a living.

Why then are most money-motivated books called things like The Millionaire Next Door or Secrets of the Millionaire Mind? A million isn’t what it used to be, but it’s still more than most of us need for financial freedom.

What we’re really looking for is a replacement for our salary. The number on your pay check is the number you need to beat to retire early. If your monthly wage turned up in your bank account no matter what you did, wouldn’t you feel pretty financially free? You could quit work the next day if you wanted, although there’s no reason to take to the golf course – you could get a fun job, work for charity, or do all sorts of other exciting things instead.

Why you should consider targeting income instead of capital

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Part One of this series introduced how dividend payments from shares can produce a growing income stream with minimal effort on your part, and certainly no need to frenetically ‘play the markets’ like a demented monkey bashing the bongo drums. (Remember, study after study has proven most share traders fail to beat buy-and-forget tracker funds over the long-term).

Now we’ll consider in detail what makes a particular share an attractive candidate for a portfolio of high yield shares (known as a High Yield Portfolio or HYP). Part Three will outline how to assemble 15-20 such shares that complement each other by drawing their earnings from different industries, and thus avoid you having all your eggs in one basket. Part Four will demonstrate with real examples from the London stock market the construction of such a portfolio.

While we’re consider high yield shares in isolation below, keep in mind that holding only one high yield share (or several in the same sector, such as banking) is far too risky for our purposes: we’ll look at how to reduce the risks of picking a duff share below, but the greater protection comes from the portfolio approach explained in Part Three.

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“Buy! Buy! Buy!” shout the city folk in blue braces from one side of the trading pit. “Sell! Sell! Sell!” retort those with red neckties.

Whatever happened to “Wait! Wait! Wait!” wonders your writer?

These days sharetrading is conducted via computer – the trading is often done automatically according to decisions made by the computers themselves – and the drama of the buyers and the sellers at loggerheads is consigned like steam engines and home brewing to our rosy-tinted memories of yesteryear. Institutions and individuals alike now haggle over shares in front of screens that blink red and blue, with more arrows, buttons and switches than a computer game.

When trading platforms look like fruit machines, it’s no wonder investors behave like short-term gamblers. But there’s a way of profiting from holding shares that requires no selling at all, by receiving the (generally) twice-a-year dividend.

The dividend is the money a company pays every shareholder out of its retained profits, as a reward for holding its shares. It’s too often forgotten that as a shareholder in a company, you’re a part-owner in its business. The dividend you receive is your share of the annual earnings.

Annually, the amount paid out by companies in the London stock market as dividends is about 2-3% of the entire market capitalisation. Some shares pay more: several UK banks, for instance, are currently paying the equivalent of over 6% of their market capitalisation in annual dividends. Others, typically high tech or loss-making companies, don’t pay any dividend.

The amount paid out as a percentage of your shareholding (such as the 6% just cited) is called the yield of the share. There’s more detail elsewhere on Monevator.com regarding calculating the dividend yield; for now it’s enough to know that shares paying relatively high dividends are known as high yield shares.

Do the small percentage returns from dividends sound dull to you? Sure, you won’t hear much about dividends from excited market pundits on CNBC and Bloomberg, who prefer to scream that the price of Wibbly Wobbly PLC has fallen by 0.2% in early morning trading.

What if I was to tell you that over the long-term, the bulk of profits made from investing in the stock market have historically come from receiving and reinvesting dividends?

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