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Selecting the shares for your high yield portfolio: HYP part 4

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Previous posts in this high yield share investing series have argued the case for dividends, considered what makes a good high yield share, and stressed the need for diversification. Now it’s time to make yourself a cup of tea and settle down to see exactly how you can construct a high yield portfolio for yourself.

This is probably one of the most detailed (or long-winded!) run throughs of portfolio construction on the Web, but it should help your understanding to see the thought processes for yourself. I hope you enjoy it – or failing that at least stay awake…

First pass: be a screen demon

In the past, canny old boys after a bit of high yield would scan the share listings in the Financial Times with a gnarly finger, gasp when they alighted upon a suitably plump dividend payout, and interrupt their stockbroker’s lavish lunch to ask if he knew of any problems with the company – for which service the broker would eventually dock a hefty percentage fee on investing.

These days we can do almost the same thing with far less financial outlay (or stockbroker obfuscation) by using a data service such as Digital Look’s share screener (registration required – but it’s free for what we need), and by checking the company’s reports online.

A share screener is basically a sieve that you can use to filter out companies with particular characteristics from the thousands available on the market. Whether you’re hunting for high growth shares, companies with lots of cash on their books, or those paying decent dividends, a screener is a quick way to locate potentially suitable investments.

That said, screeners aren’t perfect. The data from a share screener can sometimes be out of date or flatly wrong. London shares that quote their earnings in dollars often seem to screw up Digital Look‘s data, for instance.

For this reason, I recommend using a screener in conjunction with a copy of the Financial Times by your side, to at least check for inconsistencies in the dividend yields being quoted. If you’re investing your hard-earned money, you might well want to double-check the dividend forecasts in the companies’ reports, and calculate the yield for yourself. Remember to triple check anything overly high; at the time of writing, a yield of 10%-plus is almost certain to indicate that the dividend will be cut).

One specific niggle with Digital Look‘s screener is that it can’t seem to check for gearing properly. The figures are there for each company, but screening for a maximum gearing of 50% throws the results out of whack. For this reason, I’ve not included gearing in my initial ‘pass’ through the screener below, but have instead checked the debt situation manually after drawing up a shortlist.

You can also ascertain the gearing ratio by skimming through the company’s most recent reports for the appropriate figures, then calculating the gearing yourself. Gearing is never an exact science (a company may borrow say £100 million the day after its reports are signed off) but it’s better than nothing as a guide to debt.

An alternative for double-checkers is to pay up for a subscription to a second data source like HemScott or the low-fi Sharelock Holmes, or to buy and collect the print edition of the Investor’s Chronicle. An Excel spreadsheet of FTSE350 shares with an emphasis on high yield is also made available by a private investor, though unfortunately it’s only updated occasionally.

Having two share screening tools really helps you compare and contrast, and thus to ferret out any inconsistencies, or point up further research to be done in the company reports.

Given that the HYP method is focused on Long Term Buy and Hold, however, you might soon have no use for either if you’re setting up a ‘fire-and-forget’ portfolio.

Checking the company reports and doing any maths required isn’t really much work if you’re buying a share you could own for decades.

But as ever, it’s your shout.

A High Yield Portfolio filter: worked example

As already discussed, there are no hard and fast rules when constructing a high yield portfolio. One investor might give more weight to the companies growing their dividends fastest, another ignore sector diversification and simply pick the highest yield shares (I wouldn’t!), and a third set a maximum company size, rather than a minimum, to try to find small, potentially overlooked cash fountains.

Whatever fundamentals you’re after, you simply set up your screener as appropriate, and away you go.

Not surprisingly, for Monevator.com‘s own high yield portfolio we’re going to set the screener with the parameters we previously outlined as attractive for high yield shares in Part Two of this series.

To recap:

  • We only want big UK shares, so we will select from the FTSE 350 Index
  • We’re looking for high yield shares. With the average yield of the FTSE 100 currently shimmying above and below the 3% mark, we’ll screen for shares with a historical and forecast yield of at least 3%
  • Size of company: we’ll screen for a market capitalisation of least £1billion
  • Dividend cover of 1.5 or better
  • Dividend growth record: No recent cutters allowed, but flat forecasts may be acceptable if the starting yield is particularly high. We’ll screen for historical and forecast yields of at least the same size, then check the records on a per share basis
  • Gearing ideally less than 50% – but as noted elsewhere, banks and utilities don’t fit this criteria. Also, as discussed above I don’t like the way Digital Look treats gearing. I won’t screen for gearing, then, but will instead check the gearing individually as I draw up my final list

First pass results from the screener (as of 26/09/07)

Note: Even more than usual, the shares mentioned from here on are NOT a recommendation to buy. Besides the fact that you must always make and be responsible for your own decisions, you are probably reading this article long after it was written, by which time the share data here will be out of date! It is meant only as a worked example to show you how you can pick your own high yield portfolio.

Entering all the parameters above into Digital Look‘s screener and pressing ‘Run Screen’ throws up 48 companies that meet our criteria. We’re looking for 20 in total, so it’s time to get the scissors out.

The first step is to ensure the critical HYP sector diversification we discussed in Part 3. Below I’ve listed all the 48 shares by forecast yield, together with their sector. (When doing this for yourself you can find out the sector by clicking on the share’s name in the listing and reading the overview.)

Note that sector names vary between publications and data services – these are my own simplified sectors below. Also note I’ve quoted the forecast yield. (This is the payout we can look forward to getting our sticky mitts on.)

Name                    F Yield  Sector
Alliance & Leicester 	8.10%	Bank
Royal Bank of Scotland	6.70%	Bank
Tomkins 	        6.40%	Engineering
Taylor Wimpey 	        6.20%	Building
Persimmon 	        5.80%	Building
Cattles 	        5.80%	Financial
HBOS 	                5.80%	Bank
Barclays 	        5.70%	Bank
Investec 	        5.50%	Financial
Kesa Electricals 	5.30%	Retail
BT Group 	        5.00%	Telecoms
Barratt Developments 	5.00%	Building
Close Brothers	        4.90%	Financial
Hiscox 	                4.80%	Insurance
HSBC Holdings 	        4.80%	Bank
Royal & Sun Alliance	4.70%	Life assurance
Aviva 	                4.60%	Life assurance
Friends Provident 	4.60%	Life assurance
Legal & General	        4.50%	Life assurance
Yell Group 	        4.50%	Media
Old Mutual 	        4.50%	Life assurance
Amlin 	                4.40%	Insurance
Signet Group 	        4.40%	Retail
Pearson 	        4.20%	Media
National Grid 	        4.20%	Utility
Wolseley 	        4.20%	Building
Intermediate Capital	4.20%	Financial
Tate & Lyle 	        4.00%	Food&Drink
Scottish & Southern     3.90%	Utility
GKN 	                3.80%	Engineering
Inchcape 	        3.80%	Retail
LogicaCMG 	        3.80%	Software
GlaxoSmithKline 	3.80%	Drugs
British American 	3.70%	Tobacco
William Hill 	        3.70%	Gambling
IMI 	                3.70%	Engineering
Northumbrian Water	3.70%	Utility
Misys 	                3.70%	Software
AstraZeneca 	        3.60%	Drugs
Centrica 	        3.60%	Utility
BP 	                3.50%	Oil
Marks & Spencer 	3.50%	Retail
Rexam 	                3.50%	Engineering
Ladbrokes 	        3.40%	Gambling
Scottish & Newcastle 	3.40%	Food&Drink
Pennon Group 	        3.30%	Utility
Unilever 	        3.20%	Food&Drink
Diageo 	                3.20%	Food&Drink

Immediately we can see there’s sector duplication in these 48 shares – there are five utilities, for instance, and as many banks.

This abundance of high yielders in particular sectors is typical when constructing HYPs, partly because certain sectors like banking tend to always be good dividend payers, but also because whole sectors swing in and out of fashion according to fear and greed among investors.

The economic cycle also plays a part. Four or five years ago a screen like this might have unearthed several attractive mining shares with yields in excess of 3%. Not anymore.

One option to get our 20 shares would be to simply select the top 20 highest yielders, but this would not give us the sector diversification we crave. There are 16 sectors here, and ideally we want a share from each sector in our portfolio.

Selecting the highest yielding share from each sector gives us the following shares:

Name                    Yield   Sector
Alliance & Leicester 	8.1%	Bank
Tomkins 	        6.4%	Engineering
Taylor Wimpey 	        6.2%	Building
Cattles 	        5.8%	Financial
Kesa Electricals 	5.3%	Retail
BT Group 	        5.0%	Telecoms
Hiscox 	                4.8%    Insurance
Royal & Sun Alliance	4.7%	Life assurance
Yell Group 	        4.5%	Media
National Grid 	        4.2%	Utility
Tate & Lyle 	        4.0%	Food&Drink
LogicaCMG 	        3.8%	Software
GlaxoSmithKline 	3.8%	Drugs
British American 	3.7%	Tobacco
William Hill 	        3.7%	Gambling
BP 	                3.5%	Oil

Not a bad little portfolio, and 16 would be enough shares for some. We’re after 20 shares though so we need to double up on a few sectors. Here the choice comes down again to personal tastes.

For instance, at the moment banking shares are in the doldrums – not surprising given that we’ve just seen the first run on a bank in Britain in over 100 years. You might think that means banking shares should be avoided, or you might believe that The Bank of England’s guarantee to savers will stop another bank reaching such lows.

Which view is right? Whatever anyone tells you there’s no way to be sure, which is why share prices go up and down all the time. Every company and every sector has its critics and its bad patches, and if you listen to all of them you’ll never invest in anything.

Remember, the very reason we can benefit from high yield shares is because companies can become oversold on excessive fears – at least until the day they go bust and the market is proved right. That’s the ‘game’ we’re playing.

What to do? It’s up to you, but unless I can find reports from the company pointing to concrete threats to the dividend or the company’s future, I tend to concentrate on the numbers, and on sector diversification.

Going down the original list, then, I’m looking for the four highest yielding, attractive looking shares, in four different sectors.

First up comes Royal Bank of Scotland. It’s more than 15 times bigger than Alliance and Leicester and is a far more diversified global business than the next bank on the list, HBOS, which is kind of like A&L on steroids.

Now, I happen to know RBS is locked in a bidding war for ABN Ambro at the time of writing, which some in the city like and some don’t. Personally I haven’t got a clue if it will boost RBS’s earnings and dividend or imperil them, so I deliberately leave the bid out of my thought process. I’m confident RBS will be big enough to ride out any problems, and I’m happy to buy.

Next up is a second builder, Persimmon – a far smaller company than RBS, and in a notoriously cyclical industry. I’d rather have only one builder in my portfolio, so I’ll skip this and the other extra building shares thrown up by my initial screen. I suspect they would all respond very similarly to swings in the housing market – not ideal for diversification.

The third sector to be duplicated is ‘Financials’, with Investec forecast to yield 5.5%. It’s a fund manager that’s been hit like banking by the credit crunch, and by fears about its sub-prime mortgage book.

This is a trickier decision – at £2 billion Investec is not a truly giant company, and with RBS and A&L it would see me exposed on three fronts to the current credit crisis. On the other hand, it has an excellent 20-year track record of paying dividends, albeit originally on the South African stock exchange. On balance, Investec is going into the portfolio.

The next duplicated sector is Life Assurance. Aviva, better known to consumers as Norwich Union, is an £18 billion monster, and it could be a good addition to our high yield team. However, its addition would increase the number of financial companies in the portfolio to seven – too many in a 20-strong line-up.

What about swapping Investec with Aviva? The latter is a far bigger company, but Investec’s business is fund management, which is not represented by the other five financials confirmed so far. For that reason I’m keeping Investec and skipping Aviva and the other Life Assurance outfits.

The next duplicated sector is Insurance, and Amlin. I have Hiscox in this sector already, and as I’ve just said there’s enough financials in the portfolio, so I’m going to skip past this.

Moving down the list we come to the Signet group – a retailer specialising in jewelry. It’s not a huge company at £1.4 billion but it’s clearly in a very different sector to our other retailer, the electrical goods shifter Kesa, and its dividend record is fine. Digital Look has analysts suggesting earnings will fall next year, but the dividend will be increased, with dividend cover of 2 providing some security.

In my experience, retailers are often the most hesitant additions to a high yield portfolio, since unlike many companies we all have contact with shops in our daily lives. Therefore, rather than speculate further about the future of jewelry retailing (the company is valued at well over a £1billion, so clearly a lot of people think it has a good future – and I have girlfriends who would agree) I’m going to add Signet to our line-up.

We still need one more share. Moving down we come immediately to the Financial Times owner Pearson, in the Media sector. The company also owns Penguin and has a huge educational wing. All this well-diversified intellectual property bodes well for its ability to sustain future dividends, so into the pot Pearson goes.

To recap, we’ve added: Royal Bank of Scotland, Investec, Signet and Pearson to our High Yield Portfolio to bring it up to 20 shares, as follows:

Name                    Yield   Sector
Alliance & Leicester 	8.1%	Bank
Royal Bank of Scotland	6.7%	Bank
Tomkins 	        6.4%	Engineering
Taylor Wimpey 	        6.2%	Building
Cattles 	        5.8%	Financial
Investec		5.5%	Financial
Kesa Electricals 	5.3%	Retail
BT Group 	        5.0%	Telecoms
Hiscox 	                4.8%    Insurance
Royal & Sun Alliance	4.7%	Life assurance
Yell Group 	        4.5%	Media
Signet Group		4.4%	Retail
Pearson			4.2%	Media
National Grid 	        4.2%	Utility
Tate & Lyle 	        4.0%	Food&Drink
LogicaCMG 	        3.8%	Software
GlaxoSmithKline 	3.8%	Drugs
British American 	3.7%	Tobacco
William Hill 	        3.7%	Gambling
BP 	                3.5%	Oil
Average Yield 	4.9%

Checking for overly indebted companies via gearing

So, we’ve 20 shares, with a forecast yield overall of 4.9% (rounding up). Not bad, but I need to be as sure as I can be that those dividends will be paid. In a crunch, interest is always paid before shareholders’ dividends – indeed, too much debt can doom a company in a slowdown – so I want to make sure that none of our 20 companies are overly indebted.

By clicking on any particular company in the Digital Look share screener, I can get an overview of its business, see its record on paying dividends, and check out its gearing.

Gearing is a controversial subject, with many different ways to measure it, and indeed views on the pros and cons of taking on debt. For this exercise I’ll use Digital Look‘s ‘Net Gearing’ figure. You can locate this by clicking on a particular company name in the screener results, then by clicking on its ‘Financials’ tab, and then on ‘Fundamentals’. Scroll to the bottom and you’ll find the gearing.

First off, we can discount gearing as a factor with our six financial companies. Banks and the like borrow and relend money as a matter of everyday business, making their gearing incredibly tricky to get a handle on. The best practical advice is to ignore it.

That leaves 14 companies. Eight of them have gearing under 50%, leaving the following six to query further:

Name                    Gearing	Sector
Kesa Electricals 	53%	Retail
BT Group 	        126%	Telecoms
Yell Group 	        59%	Media
National Grid 	        273%	Utility
Tate & Lyle 	        93%	Food&Drink
William Hill 	        75%	Gambling

The obvious one that jumps out is National Grid, with a staggering 273% for gearing. Surely it should go?

I’d argue not. National Grid is a utility, and as its name implies it’s a near monopoly provider of the power infrastructure in the UK. There’s no chance of electricity going out of fashion any time soon, and even a recession needn’t dent National Grid’s earnings.

This security of income means banks are willing to lend huge amounts to utilities, and since the regulation that comes with near monopoly status restricts the prices utilities can charge, gearing is often required to improved the return to shareholders.

If you want a utility in your HYP – and while they’re not the super high yielders they once were, I do – then high gearing typically comes with it. National Grid stays.

Next we find BT. Controversially, I think one can consider BT a quasi-utility, since so many homes still have a BT line as standard. This is changing (the fixed line business is declining, as its ‘enterprise’ business grows) but not overnight, and besides, BT has done a good job of bringing its gearing down over the past few years, even as it has increased its dividend. BT stays.

The other four look more dubious. Kesa is a retailer of high-tech ‘toys for the boys’. Debt would be a huge drag in a sales downturn, and the dividend would be cut if profits fell and there was interest to be paid. Kesa gets the chop.

Yell, which produces the Yellow Pages, was probably saddled with debt when it was floated a few years back. Dividend cover is good at 2, and it’s got a good record since 2004 of hugely increasing dividend payouts (9p per share in 2004 versus a forecast 18p for 2008 – a doubling in four years – is not to be sniffed at!)

What’s more, Yell is over £3billion in size, which is reassuring.

More research is needed. Looking at the company’s latest report (via ‘News’ and then ‘Regulatory News’ under its entry in Digital Look) I see that underlying cashflow at Yell is very strong. Yet its net borrowings stand at over £3,500 million – more than the market capitalisation of the company!

In its accounts Yell offsets its liabilities largely against ‘intangible assets’ approaching £5 billion. Such is the brand value, apparently, of the Yellow Pages.

Yell is no doubt able to cover its interest payments quite easily while cashflow remains strong, but a look at its ‘Key Performance Indicators’ suggests its printed book business is falling, with internet income only a tiny, if fast-growing, contributor.

According to this speedy reading (do your own research if investing!), Yell then is a classic judgement call.

Personally, I like its track record and the unique business proposition – perhaps if the split between printed and Internet income was more balanced I’d invest. But with the huge debt hanging over it, I fear a collapse in its main income source would seriously imperil the dividend. For that reason, Yell is out of our portfolio.

Turning to Tate & Lyle, a similar process reveals Net Debt has increased over recent years, albeit modestly. In its latest report, the company claims interest payments are covered over 10 times by income.

A quick skim through these results also finds Tate & Lyle buying and selling subsidiaries for hundreds of millions of pounds with the abandon of a market trader on a sugar rush, which shows how you have to take any snapshot of gearing with a pinch of salt (or with Tate & Lyle’s Splenda sweetener).

At £2.7 billion, Tate is a sizeable concern and its dividend track record is good. While it’s hardly more diversified than Yell, it does have both natural and artificial sweeteners in its range, and I can’t see the human race’s sweet tooth going away just yet. (It also claims to be the global number one in ‘industrial starches and wheat proteins’, for what that’s worth).

With some trepidation, I’m leaving Tate in the portfolio.

Finally, the bookie William Hill. As you’d expect if you’ve ever gambled, cash pours into the business, which will greatly help with those interest payments. Oddly though, according to Digital Look there was no Net Gearing at all until the report dated December 2006. Weird, and so into the Interim Results (as of 2nd August 2007) we go.

Under ‘Dividend and capital structure’, the directors claim to be carefully managing debt in relation to earnings, and point out the company has bought back shares in the past few years (an alternative method to dividends of returning cash to shareholders, though not as attractive in my eyes). However, a comparison of the company’s long term liabilities (over £1billion, even after removing cash at hand) to the shareholder’s funds (or ‘equity’ in these results) isn’t for the squeamish.

The business model at William Hill appears to be Money In / Money Out, almost like a bank, and there’s perhaps a case for considering it a Financial company. Even by that benchmark though I’ve reached my limit with six financials, so with regret William Hill and with it the gambling sector has to go.

Finding replacement shares: step and repeat

So that’s three highly geared keepers, and three to be replaced – Kesa, Yell and William Hill. To do this, I return to my original listing of high yield candidates and go through the same process of sector diversification first, then checking gearing second. I start at the entry after my last ‘duplicator’, which was Pearson, making Scottish and Southern Energy, a utility, the next share to consider.

To cut a long story short, I decide to add:

Name                    Yield   Sector	Gearing
Scottish and Southern 	3.9%	Utility	79%
InchCape	 	3.7%	Retail	45%
IMI			3.7%	Eng.	27%

Recalculating the average portfolio yield gives me 4.81%, a tiny reduction for the security of getting rid of all that debt.

Still awake? Good – we’re nearly there. All that remains is to check that none of these companies have ever dared to cut their dividends.

Checking the dividend record

Confirming a flat or rising dividend over recent years for each company is easily, if tediously, done via Digital Look. You simply click on each company in turn, then check its record of dividend payments in the second column from the right (entitled ‘Div’, under ‘Fundamentals’.

We’re looking for any evidence that dividends have been cut in the past few years by our portfolio constituents.

Two companies have clearly done so – Royal & Sun Alliance in 2003 (it reduced its dividend slightly) and LogicaCMG (the dividend roughly halved, growing steadily since then).

Two other shares also need a word. Tomkins held its dividend flat a few years ago before resuming increases, which I find acceptable. BP’s yield is forecast to drop, but a look at its dividend record in Digital Look suggests that’s due to currency conversion factors (it declares its dividend in dollars). No payout cuts are currently forecast, and cover is good. The oil sector is an essential in my opinion, and BP is a giant. BP stays.

I’m also happy to give Royal & Sun Alliance the benefit of the doubt; it was a torrid time for Life Assurance companies in 2003, with stock market falls hitting their underlying investments hard. It bodes well I think that RSA got by with merely trimming its dividend.

LogicaCMG is another story. As a software company, it doubtless suffered in the bear market that followed the Dot Com crash in 2000. However halving the dividend is a serious offence for a high yielder, and it can’t be overlooked. LogicaCMG gets the boot.

Our original screen threw up an alternative in this sector – Misys. A smaller company, it nevertheless has kept up increasing payments for the past few years. However, that’s come at a cost of falling dividend cover (just 1.6 times next year’s payment) as earnings per share have fallen, and, even worse, gearing is calculated at 80%.

Unfortunately, the software sector looks too erratic for our purposes. Instead I return to the original listing and look for a new candidate in a sector that’s not been duplicated so far, which means we’re heading down to the very bottom of the 48 shares.

First up comes Ladbrokes, which I’m rejecting like fellow bookie William Hill on the grounds of gearing. Next comes Scottish and Newcastle, which I reject on the grounds that it cut its dividend in 2003.

Finally we come to Unilever – a huge £25 billion company in Food & Drink, which also owns the likes of Vaseline and Persil. Net gearing is a very appealing 30%, and the dividend record is of slow but steady growth.

The price for all this stability is a low yield – at 3.2% only just above the market. However Unilever adds nicely to the diversification of our new High Yield Portfolio, and brings us back to our full complement of 20 shares.

The cost of bringing such a relative low yielder into our 20-strong portfolio is barely reflected in the overall yield, which is now down a smidgen to 4.78% (to two decimal places). Not bad at all.

The final High Yield Portfolio (as of 26/09/07)

[TABLE=4]

Overall Yield 4.78%

Key: FY = Forward Yield (%); HY = Historic Yield (%); Size = Market Capitalisation (in £millions); Cover = Dividend cover; Sector = rough sector classifications; Gearing = Gearing (%)

Remember, this is just a suggestion as to how to pick a high yield portfolio. Some investors will be less cautious about dividend cover, for instance, bringing in higher payers (Lloyds TSB and United Utilities in particular, on today’s prices), while others will be even stricter about gearing, or put more weight on the historic yield.

There are no rules – that’s what makes it a market – but I hope I’ve given you an outline that you can tweak, with input from an advisor if required, for your own purposes.

Final thoughts and goodnight

Investing in the portfolio we’ve just constructed would promise you a future return of 4.78% in the first year, compared to 6% in the best cash savings account at the time of writing. Given that dividends are more favourably taxed than interest on savings (they’re effectively tax free for lower rate payers, or taxed at 32.5% if you’re on the higher rate) that’s a pretty attractive comparison.

What’s more, I’d expect the dividend income to increase over time by around 3-5% per year overall.

The flipside is share prices go up and down. Investing £5,000 in each of these 20 companies would give you a high yield portfolio of £100,000 and, hopefully, an initial annual income of £4,780. But the dividend income (perhaps) and the capital (definitely) will fluctuate.

As we saw above, the companies chosen have steadily increased their dividends over the past five years, but during the same time their share prices have been all over the place. Diversification helps dampen the swings, but it’s still perfectly possible that your £100,000 HYP might be worth £70,000 in a year’s time, or £130,000, or anything above or below that.

This volatility is the price you pay for investing in shares, and the reason why only long-term funds that you don’t expect to need for at least 5-10 years should be invested in the stock market. Even then, you need fortitude to sleep through a drop of 30% in your portfolio’s value – nervous selling when share prices fall is a guaranteed loss-making strategy!

Indeed, HYP popularizer Stephen Bland writes on The Motley Fool that the best idea is to ignore your portfolio’s value entirely:

My suggested approach to the whole strategy, which I intended for the hands-off investor, is simply to forget about it once invested, don’t follow the shares, don’t listen to any comment, just enjoy the income. Perhaps take a peek at it once every decade or so if you feel you have to get involved in some way.

A radical suggestion for Monevator.com readers, perhaps, but a realistic one for the majority of people who aren’t excited about investing. Just remember that if you do monitor your portfolio you’ll be constantly tempted to trade, and that share trading tends to lower returns for most people over time.

On a brighter note, let’s imagine that your £4,780 dividend income increased at 5% a year. After 10 years you would be enjoying an income of £7,786 a year, and after 20 years £12,683. Sounds good, but remember inflation – you’ll probably be only modestly ahead after 20 years. Still, much better than cash savings, where your income would never grow, except with gyrations in the bank’s interest rate.

What if you save rather than spend your income? Reinvest your dividends to grow your portfolio and you can hope for far greater returns. Let’s suppose share prices increased at the same rate as the dividend, which is a reasonable assumption over two decades.

Reinvesting your income, you’d be looking at 10% growth overall – after 20 years, your £100,000 initial investment might be worth north of £650,000, and yielding in excess of £30,000 a year.

That’s an ambitious forecast, to be sure – I’d be more comfortable estimating a 7% return over that time (or say a 4% real return after 3% inflation), giving you around £385,000 in 20 years time, or £180,000 in today’s money. Not spectacular, but a safer bet. Anything extra would be a bonus.

Again, it can’t be stressed enough that there are no promises in share investing – deep bear markets have savaged returns in the past, and may do again.

Assuming you decide to risk share investment and the high yield approach, other issues to consider include how you buy your shares – all at once, or at intervals via savings – and how you maintain your portfolio as time goes by and things happen to its constituents.

We’ll look at these issues in Parts 5 and 6, so click here to subscribe to the RSS feed to ensure you don’t miss out!

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Comments on this entry are closed.

  • 1 jasbir khurl January 7, 2009, 8:53 pm

    Hello. Can you recommend a broker that I can use to set up the dividend reinvestment or how do I set up the dividend reinvestment. I currently buy shares through http://www.share.com, I spoke to them and they do not have the facility to get dividends reinvested.

    Thanks

  • 2 The Investor January 8, 2009, 2:28 pm

    Here in the UK you can use the Halifax Sharebuilder account to do this. Does Sharebuilder in the US offer the same service?

    Please don’t take this as a recommendation though – just an idea.