Start from the income you need, not the highest yield

You will be able to set an income target and see what yield and capital it implies.

Ask most people what they want from an income portfolio and they start with a yield. Six percent sounds good, eight sounds better. Wei Ling did the same when she first sat down to plan, and her friend Darren, who had spent months on REIT scorecards, asked her a different question: how much money a year do you actually want it to pay, and what do you have to put in?

That question is where this module starts. The yield comes out of the answer.

Work backwards from the income

Write down two numbers. The first is the yearly income you want the portfolio to pay, measured at today's prices. Be specific about what it is for: a top-up to a salary, a sum to cover insurance premiums, a share of living costs later in life. The second is the capital you have, or expect to have, to invest for income.

Divide the first by the second. That is the yield you need.

With made-up figures, Wei Ling wants S$12,000 a year and has S$300,000 to invest. She needs a yield of 4%. If she had S$200,000, she would need 6%.

That simple division changes the conversation. In place of asking which holdings pay the most, you ask whether your target yield is in line with what solid, covered payers offer, using the scorecards you built in lesson 2.5, Score three dividend payers, and lesson 5.5, Build a REIT scorecard.

When the yield you need is too high

Say the yield you need is far above the range your scorecards showed for payers with covered dividends, healthy debt and steady growth. The tempting answer is to reach for the higher yields at the top of the screener. Module 3 showed where that leads. The highest yields are often the ones the market expects to be cut, and a yield trap does not pay the income you planned on.

There are better answers, none of them exciting. You can add more capital over time. You can give the portfolio more years to grow before you draw from it. Or you can lower the target, at least to start with. Each of those deals with the gap honestly. Chasing yield only hides it until the cuts arrive.

Income has to keep up with prices

A target of S$12,000 a year at today's prices will not stay S$12,000. How money works lesson 4.1, Inflation means the same dollar buys less each year, showed why. With a made-up inflation rate of 3% a year, keeping the same buying power would take about S$16,130 a year after ten years. Put the other way, a flat S$12,000 would buy what about S$8,930 buys today. By the rule of 72 from How money works lesson 2.3, prices at 3% double in about 24 years.

So an income portfolio needs income that grows, not just income that starts high. Lesson 2.3, Dividend growth and what it says about the business, showed how a lower starting yield with steady growth can overtake a higher flat one. When you set your plan, look at the growth column in your scorecards as carefully as the yield column. A portfolio of high payers that never raise their dividends gives you a shrinking real income.

Judge it on total return

The last point is the first lesson of the course, applied to the whole portfolio. Lesson 1.1, Why the share price drops on the ex-date, showed that a dividend is part of your investment paid back to you, and that the only fair measure is total return: price change plus income.

For a portfolio, that means checking two things each year. Is the income meeting the target? And is the capital holding its value, or growing? If 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. Part of it was your own capital, handed back to you in a way that reduces next year's income too.

A yield paid out of shrinking capital is not income. It is a slow withdrawal, and it is exactly what a portfolio of yield traps produces.

A total return view

So alongside your income target, write down what you expect from the portfolio's value over time, in broad terms. Something like: capital at least keeping pace with inflation over five years, income rising over time. That gives you a second test to apply each year, and stops a high yield from hiding a falling portfolio.

Wei Ling's 4% target turned out to sit comfortably inside the range of her better-scored holdings. Her first plan, built on 7%, would have needed most of her money in the stocks her scorecards ranked lowest.

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 your income target, your capital and the yield that implies, and compare it with the yield range of the scorecards you built.

Course

• Dividend stocks and S-REITs