Set an income target and work out the yield and capital it calls for.
Wei Ling is putting together an income portfolio. When she first sat down to plan it, she did what most people do and started with a yield.
Most income plans start with a number like 6% or 8%, because six percent sounds good and eight sounds better. Then comes a search for holdings that pay it. That's the wrong place to start. Begin with two questions instead: how much money a year do you want the portfolio to pay, and how much do you have to put in? Once you have those two answers, the yield follows from them.
Wei Ling's friend Darren spent months building REIT scorecards. Darren asked her exactly those two questions. Write your own answers down as two numbers. The first is the yearly income you want, measured at today's prices. The second is the capital you have, or expect to have, to invest for income.
Be specific about what the income is for. It might top up your salary, cover your insurance premiums, or pay a share of your living costs later in life. A target with a named purpose is easier to set and easier to check.
Then divide. The yield you need, also called the implied yield, is your yearly income target divided by your capital. Wei Ling wants S$12,000 a year and has S$300,000 to invest (both are example figures). S$12,000 / S$300,000 = 4%, so she needs a 4% yield. If she had S$200,000, she would need S$12,000 / S$200,000 = 6%.
Once you know the yield you need, you stop asking "which holdings pay the most". You ask "is my target yield in line with what solid payers with covered dividends offer". The scorecards you built in Lesson 2.5, Score three dividend payers, and Lesson 5.5, Build a REIT scorecard, answer that. Look at the range of yields among the holdings that scored well on covered dividends, healthy debt and steady growth.
Wei Ling's 4% sits comfortably inside the range of her better-scored holdings. Her first plan was built on 7%. To get 7%, she would have needed most of her money in the stocks her scorecards ranked lowest.
If the yield you need is far above the range your scorecards showed, it's tempting to go to the screener and buy the highest yields. Module 3 showed that the highest yields are often the ones the market expects to be cut. A yield trap does not pay the income you planned on.
There are three better responses, and none of them is exciting. You can add more capital over time. You can give the portfolio more years to grow before you start drawing from it. Or you can lower the target, at least to start with. Each of these deals with the gap honestly. Chasing yield only hides the gap until the dividend cuts arrive.
An income target set at today's prices will lose its value over time. How money works lesson 4.1, Inflation means the same dollar buys less each year, explains why. Take 3% a year as an example inflation rate. After ten years, Wei Ling would need about S$16,130 a year to buy what S$12,000 buys now (S$12,000 x 1.03^10). If her income stays flat at S$12,000, in ten years it buys what about S$8,930 buys today. Using the rule of 72 from How money works lesson 2.3, prices rising at 3% a year double in about 24 years (72 / 3 = 24).
This means an income portfolio needs income that grows, as well as income that starts at a useful level. Lesson 2.3, Dividend growth and what it says about the business, showed that a lower starting yield with steady growth can overtake a higher yield that stays flat. When you plan, read the dividend growth column in your scorecards as carefully as the yield column. If your portfolio is full of high payers that never raise their dividends, your real income shrinks every year.
Lesson 1.1, Why the share price drops on the ex-date, the first lesson of the course, showed that a dividend is part of your investment paid back to you. The only fair measure is total return: price change plus income.
Each year, check two things for the portfolio as a whole. Is the income meeting your target? Is the capital holding its value or growing? Suppose you collect S$12,000 a year while the portfolio shrinks from S$300,000 to S$250,000. You have not received S$12,000 of income, because part of it was your own capital handed back to you. The smaller capital also means less income next year. A yield paid out of shrinking capital is a slow withdrawal, not income, and a portfolio of yield traps produces exactly that.
To make the second check concrete, write down a broad expectation for the portfolio's value next to your income target. For example: capital at least keeping pace with inflation over five years, and income rising over time. That gives you a second test to apply each year, so a high yield can't hide a portfolio that is falling in value.
In the activity you will write your own target, capital and implied yield, and set them against the range from the scorecards you have already built.
Write down your income target, your capital and the yield they imply. Then compare that yield with the range on the scorecards you built.
Junxiong-WFG Organisation is an authorised representative of AIA Financial Advisers Private Limited (Reg. No. 201715016G).