What Are Different Types of Investments?
Investments are generally categorised by analysts and brokers as falling into certain "styles," depending on the strategies and objectives of whomever is doing the investing. For equities and mutual funds, some of the styles commonly identified include value, growth and income investments.
Value investments are investments where the investor seeks to identify assets that are underpriced in relation to their potential returns. Growth investments, as the name implies, seek growth of the value of the capital invested.
What Are Income Stocks?
Income stocks (also referred to as income investments) are considered to be investments that will produce a steady stream of regular income for the duration that the investment is held. These typically can include investments like bonds, real estate, real estate investment trusts, limited partnerships, annuities, certificates of deposit, money market funds, mutual funds and stocks.
These days, many investors buy stocks aiming to achieve fast capital appreciation through increases in share prices. This may seem like an attractive way to get rich quick through buying and selling shares. However, it can carry risks, including unexpected stock price declines, market selloffs and elevated tax costs on short-term investments.
An alternative to this strategy is the more traditional approach of seeking an income stream from equity investments, in recognition that part of the inherent value of stocks is related to the dividends they pay, or their "dividend yield."
How to Identify An Income Stock
Some stocks may pay no dividends at all. This is often the case with stocks of start-ups, such as tech companies. To pay dividends, companies need to have earnings. Firms that begin in a speculative area of operation may not have significant earnings initially and therefore take time before they pay a dividend. That was the case with many high-profile companies, such as social-media giant Facebook (FB), which didn't pay any dividends until it produced significant earnings.
Companies' boards of directors decide at their quarterly meetings whether they will pay dividends to shareholders based on the most recent earnings and how much. Companies in some sectors customarily experience stable demand and have gained a reputation over the years for paying steady dividends. These sectors include telecommunications, utilities, consumer staples, petroleum and energy, healthcare and financial services.
To determine how much a company may be able to pay, investors have traditionally relied upon the price/earnings, or P/E ratio, which is the current share price divided by 12-month earnings per share. The lower the P/E ratio, the better. Another interesting measure for investors to watch is the payout ratio, which is the last dividend payment times four, divided by the trailing-12-month earnings per share.
Dividend Yield: How Much?
The dividend yield figure is defined as four times the most recent dividend, divided by the current share price.
According to S&P Dow Jones Indices, the top 1,500 listed U.S. companies pay an average dividend yield of 2.27% annually. Some companies pay much more than that, with annual dividend yields reaching as high as 50% or more in recent years.
However, extremely high dividend yields may be exceptional. For many investors, dividends paid above the average of the broader market that beat annual inflation rates may be considered attractive.
Income Stock Strategies
Just as there are varying strategies for investment and varying income investments, there are also differing strategies for managing income stocks.
Some investors, such as retirees, may invest in income stocks to obtain a regular source of "passive income." The most obvious strategy to do this may simply be to build a portfolio of high dividend-yielding stocks and take their quarterly or annual cash payments as income. An alternative to this strategy is to establish automatic reinvestment of stock dividends to produce equity "savings" and growth of a portfolio over time.
Some investors adopt dividend growth strategies, seeking stocks that pay regular dividends and have paid increasing dividends over time. Equities advisors further recommend a "total return" strategy. This strategy considers income-producing stocks and bonds in addition to capital gains and investments that will produce attractive returns throughout a range of economic and market scenarios.
Investors may also identify certain mutual funds that group together stocks with desired dividend-paying characteristics and that pay out returns on a monthly, quarterly or annual basis.
Rewards And Risks
While income stocks are generally recognised as low risk, they are not entirely without risk and can cause declines in portfolios under certain circumstances.
Though investors may seek high dividend-yielding stocks in a slow economy, this can cause their prices to rise, thus making them expensive and reducing their relative dividend yield. One other risk of "chasing yields" is that companies that pay higher yields may then have less money on hand to invest in their future activities, eventually making them less competitive versus their peers.
Further, when interest rates rise, bonds and fixed income investments can become more attractive than income stocks. This causes the price of these securities to fall and negatively affects the value of investors' portfolios.
Dividend-yielding stocks, like other stocks, can be subject to sectoral risk. For example, oil sector stocks that produce high-dividend yields in times of high oil prices may lower their dividends when oil prices fall. Also, stocks tied to the real estate sector may pay out more during times of real estate booms, and less during times of busts.
Despite these possible risks, income stocks will remain a key cornerstone of diversified portfolios and an important consideration for investors with both aggressive and conservative investment profiles. As with any investment, be sure to do your research and/or consultant with a professional.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…