Bullet-proofing your equity income portfolio

It’s obvious, if you’re a retiree you need income. With cash and fixed interest offering low yields, equities are a good place to look for income. On the surface, it may seem easy creating an income portfolio from shares – just select stocks from a list of high dividend yielders. However, setting up an income portfolio is harder than you think.

A high yield equity portfolio for retirees will certainly deliver higher income, however, it may put their other objective of capital preservation at risk. If risk is ignored, capital losses may outweigh the income delivered. For example, owning Telstra in 2015 delivered a 6% fully franked yield over the next twelve months, but investors lost 50% of their capital over the next three years. Who cares about the income when capital is destroyed.

So here is the challenge: how does one create a high yield portfolio while preserving capital in the most volatile asset class? We know for a fact that delivering income is easy but capital preservation is hard (think about how an equity portfolio fared during the recent market correction in the last quarter of 2018). Hence, retirees who want a more holistic retirement solution should have their income portfolios mitigate risk first and only then think about yield.

Invest in Low Risk Stocks

There are several investment styles which may deliver good returns at certain times, but they may not be for the faint hearted. For example, chasing the latest momentum stocks (eg. Afterpay) where expensive stocks become even more expensive. Or bottom fishing for deep value companies (eg. Myer) where investors get lured into seemingly cheap companies with structurally challenged earnings. Both investment styles are very different, but they have something in common – they have a wide range of possible outcomes.

A low risk investment style requires investing in quality companies with a margin of safety. To deliver the desired lower risk outcomes it’s critical to have a strong valuation framework. For example, high quality companies can be poor investments if their valuations are very high, and lower quality companies can be good investments if their valuations are extremely cheap. The art is understanding the balance between a company’s quality and the margin of safety required to make the investment.

A low risk investment style may not shoot the lights out in a raging bull market, but it will preserve capital better in down markets.

Source: Vertium Asset Management (Copia Investment partner)