How to Build an Income Portfolio

LONDON -- Many investors -- including me -- invest with an eye on building an income stream. Sure, hefty capital gains are welcome as well, but it's no longer a primary concern. What matters is that income.

That said, you only have to look at the weekend money pages to see that an awful lot of people are going to be disappointed. The real, inflation-adjusted rates of return from many of the fixed-rate accounts on offer, for instance, are either negative or barely positive.

This is why, of course, a lot of people are turning to shares -- either directly or indirectly via funds.

Do it yourself
A retired pal of mine is getting a decent return from a selection of equity income funds held at one of the leading fund supermarkets. Paying a monthly or quarterly income, they supplement his pension and part-time work very nicely indeed.

But funds have a downside: the charges. A total expense ratio of 1.5% or so, in short, is quite a lot to pay for the privilege of owning stakes in boring but high-yielding blue chips such as GlaxoSmithKline, British American Tobacco, Reckitt Benckiser, or AstraZeneca.

Which begs an obvious question: Why not cut out the middleman and hold the shares directly in your own income-paying portfolio? It's perfectly possible, and many of our readers do just that; check out the stalwarts on our High Yield Portfolio discussion board, for instance.

That said, novice investors can find the process perplexing at times. So here are the major points to watch out for -- in a handy five-point plan.

Here's how

  1. Size matters. Aim for large, blue-chip businesses. Why? Because their size gives them resilience to withstand sudden shocks and adverse economic conditions. Look no further than BP (ISE: BP.L) and the Gulf of Mexico disaster, which would have sunk a smaller company.

  2. Diversify. Just as importantly, spread your risks; don't make the mistake of relying too heavily on a single company or sector. The credit crunch, for instance, found some investors with holdings in Northern Rock, Bradford & Bingley, Lloyds TSB and Royal Bank of Scotland. Whoops.

  3. Aim for above-average yields. It's an income strategy, so dividend yields matter. Today, the FTSE 100 is yielding 3.8%, so you're looking for yields comfortably higher than that. In simple terms, that means going for BAE Systems on a yield of 7.3%, rather than Rolls-Royce on a yield of 2.7%.

  4. Go for quality. These are shares for the long term. Go for businesses with low borrowings, good dividend cover (the ratio of earnings to dividends paid), and a good year-on-year history of growing those dividends. In addition to many of the shares listed above, IMI and Sage Group amply meet these requirements and offer a forecast yield of 4.5% or so.

  5. Avoid the yield trap. A strategy of ranking shares in order of yield will throw up some juicy-looking potential bargains. But the key word there is "potential." Some yields, in short, are probably too good to be true, with a dividend cut -- or worse -- lurking over the horizon. Halfords, presently on a forecast yield of 9.1%, falls into that category. Resolution is another. They might be fine. But why take the risk? There are plenty of other decent picks out there.

Getting started
So there we have it: a five-point guide to building an income portfolio. I haven't done the sums recently, but I'd be surprised if you couldn't put together a reasonably diversified portfolio, using the guidelines above, that would deliver a yield of 5% or so -- roughly 10 times Bank Rate, in other words.

That said, many novice investors fall at the first hurdle: the basics of buying shares in the first place. Here, a free Motley Fool special report -- "What Every New Investor Needs To Know" -- might just help. As I say, it's free, so what have you got to lose by downloading a copy?

And if you'd like to know the sort of shares that investment superstar Neil Woodford -- who manages a whopping 20 billion pounds of income portfolios -- thinks are decent picks, then another free Motley Fool report can also help: "8 Shares Held By Britain's Super Investor." And incidentally, those with an eye on capital gains might be interested in the fact that this stellar income investor actually turned in a gain of 347% over the 15 years to Dec. 31, 2011, versus the FTSE All-Share's 42% return -- another illustration of the power of dividends. Simply click here to download a copy, free of charge.

More investing ideas from Malcolm Wheatley:

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Malcolm holds GlaxoSmithKline, Reckitt Benckiser, AstraZeneca, BP, Lloyds, BAE Systems, and Rolls-Royce. He does not hold shares in any other companies listed above. The Motley Fool owns shares in Halfords.Motley Fool newsletter services have recommended buying shares of Halfords. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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