The 2 big risks of income strategies, and how to fix them

As part of the Livewire income series, we’ve decided to put together our own three-part focus on income, its value right now, the challenges and trade-offs when chasing income in equity markets from traditional methods, and finally an alternate solution for investors.

Part 1: Find stability in shifting market conditions

Almost by definition, market convulsions come as surprises. Sudden government regulation and intervention in China is a fresh example.

Investors often get ambushed by the market if they tend to concentrate on guessing if something will happen, instead of figuring out how to respond if (or when) it does. In economic terms, they focus on forecasting rather than positioning (who owns how much of what).

History is littered with moments where even the most storied investors didn’t predict a dramatic shift in market conditions (GFC). So if those whose job it is to analyse all market scenarios cannot be relied on to forecast the future, then it is just common sense to suggest that, rather than gazing into crystal balls, investors would be better off considering how they might be placed if global market conditions were to change abruptly. Perhaps above all they should consider if they are sufficiently diversified.

Diversification is critical to lowering risk and increasing certainty of returns.

We believe investors need to diversify in a variety of ways, but this series will focus on income, as distinct from capital growth.

Total return comprises income and capital growth, and while it is true that investors should care about the level of total return and be indifferent to its composition, in the current climate of high (sometimes extreme) starting valuations, that indifference has become risky. In many ways, it has become a code for “I have made so much from capital growth over the last few years that I have no regard for income.”

As the chart below shows, income has been a vital contributor to total returns for more than a century, and in some decades including the 2000s, was the sole contributor to total return.  

Source: Bloomberg