What income investors should learn from the Covid-19 pandemic

On a "real" life basis, last year wasn't much fun for anyone, to put it mildly.

Even if you managed to avoid being hit directly by Covid-19, you might have lost your job. And even if that didn't happen, you still spent lots of time being stuck in the house and unable to do all the things you'd want to.

But from an investment point of view, 2020 was a much more mixed bag. The crash in March was a scary moment. But if you held on - or better yet, bought in - you'd have ended the year feeling pretty happy with your performance.

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However, one group might still be feeling the pain – income investors.

So they'll be pleased to hear that some good news is coming their way – dividends are bouncing back fast...

Why the term "income investor" is a bit misleading

I've always felt that the term "income investor" is a little bit misleading.

What we really mean when we talk about income investing is "someone who needs money from their portfolio right now on a regular basis" rather than "someone who is saving up for the long run and doesn't need to touch the money".

Either of those types of investor might want to put money into traditional "income" investments such as blue chip dividend payers or solid corporate and government bonds. Even if you're saving for retirement rather than spending now, then reinvesting dividends is a great way to grow your nest egg over the long run.

Similarly, those who need an income today shouldn't get too hung up on where it comes from. Parking the tax implications for a moment, you can turn capital gains into an income just as readily as an interest or dividend payment. It just requires a slight adjustment of mentality.

So it's a bad idea to pigeon-hole yourself as either type of investor. It can lead to you being drawn to the "wrong" investments.

For example, would an income investor own bitcoin? Probably not. But they might equally be drawn to high-yielding, high-risk investments which are no more suitable in reality, but which appeal because they have the promise of that fat percentage yield dangling off the end of them.

You all know what I'm talking about.

So you're really describing a difference in risk appetite and time horizon (which are, of course, tightly interlinked) rather than an explicit set of investments.

That said... (there's always a "but") – I do have a soft spot for dividends for a couple of reasons.

Firstly, they are simple. A dividend is just cash in your pocket. That's very hard to fiddle and there's no judgement call required from the company in terms of market timing – both of which are potential problems with share buybacks, the other main way that companies use to return cash to shareholders.

Secondly, they are harder for management to mess around with. If a company cuts its dividend, shareholders generally don't like it. It's a clear sign that something has gone wrong, and that somewhere along the line, management has made a mistake - they've overpromised and underdelivered.

So they function as an accountability mechanism in a way that buybacks just don't.

This does not mean that buybacks are bad. When companies explain their rationales clearly (clothes retailer Next is probably one of the best examples here), there's nothing wrong with them. However, not all management teams are good at this stuff and so it's nice to have that safety rail there.

Lessons for income investors from the pandemic

Anyway, on that front, investment-wise, dividends were perhaps the biggest casualty of Covid-19.

Companies slashed their payouts back to 2017 levels on a global basis. The UK was particularly bad, with payouts dropping by just over a third, according to a report from Link.

However, the good news is that, according to the latest global dividend index from fund manager Janus Henderson, payouts will be back to pre-pandemic highs within the next 12 months, hitting just under $1.4 trillion this year. Payouts in the second quarter in the UK were up 60.9% year on year (the rest of Europe was even higher, at 66%).

What happened? Governments stepped in to support businesses in an extraordinary way. Demand recovered much more quickly than expected once the economy started to open up again. And as a result, companies found that they had been overly pessimistic – particularly the banks who were planning on having much bigger bad debt levels than actually happened.

If you are an income investor (or "an investor reliant on income from a portfolio", to put it more accurately), you might be breathing a sigh of relief. But it could've been very different. I remember predictions not so long ago that it would take years for dividends to recover to pre-pandemic levels.

It's also worth noting that UK dividends - while rallying - are still a ways away from recovering their pre-pandemic levels.

So what should you learn from this? Global diversification for sources of dividend income is an important one. But I think the most important thing is to ensure you always have a cash cushion. You don't want to be forced out of the market at the worst possible time (eg March 2020) because you have no other choice.

If you have – ideally – a couple of years's worth of living expenses saved up, you can draw on it in an emergency without having to worry about what your portfolio is doing. It's also useful psychologically – having that cushion there acts as a buffer against panic, a benefit which is massively under-rated in my view (another topic I discuss in my book, The Sceptical Investor).