AN EXPOSE on income investing - Part I. If you rely on dividend income (any income, really) to live on - let's say you're retired - then the chances are that, encouraged by the rest of the financial industry, you are conditioned to buying stocks that have high yields. It's traditional. But it is not very clever. Here's why.
You make less money in high-yielding stocks. Just 38 per cent of ASX 200 stocks that yield more than 6 per cent (includes franking) have bettered the ASX 200 Accumulation index over the past five years. That's capital plus dividends. Compare that with the 56 per cent of ASX 200 stocks yielding less than 4 per cent that have outperformed. The outperformance numbers over 10 years are 48 per cent for high-yielding stocks compared with 65 per cent for low-yielding stocks.
You actually make a lot less money in high-yielding stocks. The performance of high-yielding stocks is vastly lower than the low-yielding stocks because high-yielding stocks don't perform nearly as well, even when they do perform. Invest in high-yielding stocks and you'll never catch a life-changing investment such as Fortescue Metals or Paladin, which have outperformed by 61,429 per cent and 12,475 per cent over the past 10 years, not to mention the 50 per cent of stocks yielding less than 4 per cent that outperformed the ASX 200 Accumulation index by more than 100 per cent in the past 10 years.
You can't buy BHP. High-yielding stocks generally include mature businesses with nothing better to do than hand their profits on to shareholders. By definition, these companies have low growth prospects. So when you declare yourself as an income investor you're really saying, "I don't want to buy BHP." In fact, any of those stocks exposed to raging commodity prices. Nothing geared to China. In Australia, sorry but that's a crime.
It's just as risky. High-yielding stocks are supposed to be lower risk but they aren't. Declare yourself a high-income investor and you'll end up with the banks, Telstra, WA News, Envestra, David Jones, Goodman Fielder - all stocks that have underperformed the market consistently for the past 10 years. Telstra has dropped 58 per cent in 10 years, for goodness sake, and when the market fell 54.5 per cent in the GFC the banks fell 58 per cent - the CBA 62 per cent. High-income stocks are not necessarily lower risk at all. In fact, there may be more risk. Ever heard of the yield trap? Ultimately, the truth is that if you are attracted to income stocks because you want lower risk you should be in fixed interest. Equities are for growth, not income. A golden decade of bank shares in the 1990s conditioned us all to expect growth and income. That decade is over.
Capital gains are income, too, you know. A dollar of capital gain in your pocket is the same as a dollar of dividends. It doesn't matter how an after-tax dollar arrives in your pocket, whether it comes from a dividend or a capital gain. High-yielding stocks and franking are an irrelevance as long as the dollar arrives. It is all about making money, not how you make it.
Franking is a furphy. This is a slightly philosophical argument but it boils down to this - if a company makes a dollar of retained earnings, pays tax on it and then gives you 70? and you claim the 30? imputation credit, you get a dollar that is then taxed at your tax rate (or not if it's zero). If the company makes a dollar of retained earnings and keeps it, the value of the company goes up by $1 and that is reflected in the share price. You sell the share. You have made $1. If you pay zero tax, it is the same as getting the fully franked dividend. If you pay tax, it is still the same as getting the fully franked dividend. If you pay tax but held the investment for a year, you only pay half as much tax, so in some cases a dollar of capital gain is actually better than getting a dollar via a franked dividend. Capital gains and dividends, franked or not, are on a par.
Keep your correspondence to yourself for now. Part 2 for income investors next week.
Frequently Asked Questions about this Article…
What is the 'yield trap' and why should income investors watch out for it?
The 'yield trap' is the risk of chasing high dividend yields and ending up with low-growth, underperforming stocks. The article warns that many high-yielding companies are mature businesses handing profits to shareholders because they lack growth opportunities, so high yield can mask poor long-term returns and hidden risk.
Do high-yield stocks on the ASX 200 outperform low-yield stocks over time?
No. According to the article, only 38% of ASX 200 stocks yielding more than 6% beat the ASX 200 Accumulation index over five years, while 56% of stocks yielding less than 4% outperformed. Over 10 years the gap is similar: 48% of high-yielding stocks outperformed versus 65% of low-yielding stocks.
If I’m retired and need income, should I focus on high-dividend stocks?
The article suggests caution: if you want lower risk and steady income in retirement, fixed interest is a more appropriate option. Declaring yourself an income investor and focusing only on high-yield equities can exclude growth opportunities and doesn’t necessarily reduce risk.
Are high-yield dividend stocks actually lower risk than other equities?
No. The piece points out that high-yield stocks can be just as risky — or riskier — than other equities. Examples given include banks and Telstra, which have underperformed or fallen sharply in downturns (Telstra down 58% over 10 years and banks fell heavily in the GFC), showing high yield is not a proxy for safety.
How do dividends compare to capital gains — which is better for investors?
The article argues that capital gains are effectively the same as dividends from an after‑tax perspective: a dollar received from capital gain or a dollar in dividends has the same value in your pocket. It emphasizes that it’s the after‑tax dollar that matters, not whether it came from a dividend or capital growth.
Are franking credits a major advantage for Australian dividend investors?
The article calls franking credits a 'furphy' (myth) in many cases. It explains that whether a company pays a fully franked dividend or retains and reinvests earnings, investors can end up with the same after‑tax outcome — so franking shouldn’t be the main reason to pick or avoid a stock.
What are examples of big growth stocks income investors might miss by focusing on yield?
The article notes that by chasing yield you can miss life‑changing winners. It cites Fortescue Metals and Paladin as examples that massively outperformed over 10 years (Fortescue ~61,429% and Paladin ~12,475% in the article), illustrating how low‑yield, high‑growth stocks can deliver exceptional capital gains.
What practical approach should everyday investors take between income investing and growth investing?
The article’s practical takeaway is to recognise the purpose of each asset class: equities are primarily for growth (which can produce income via capital gains), while fixed interest is better suited to providing lower‑risk income. Don’t let high yield alone drive your stock selection — focus on total returns and after‑tax dollars.
Call 1300 880 160
Start a chat
Schedule a call
