Income investing has plenty of critics and plenty of investors who swear by it.

So why choose an income strategy when it comes with some very real shortcomings? In this episode of Investing Compass, Mark LaMonica and Shani Jayamanne unpack the trade-offs that come with income investing and why Mark has chosen to use the strategy in his own portfolio.

They discuss why income strategies can lag during momentum driven markets, what dividend growth can tell us about the underlying quality of a company, and why a high dividend yield isn’t always a good thing.

They also get into the practical side of picking income shares, including competitive advantages, valuation, dividend sustainability, debt and earnings growth.

You can find the full article here.

Other articles looking at income investing:

Four options for an income investor’s next dollar. Four options for investors concerned about the future of Australian dividends

Australia’s dividend drought and what income investors should do about it. Falling ETF distributions and shrinking dividend yields have raised concerns that the golden age of Australian income investing is ending.

Building wealth after the CGT changes. Higher CGT makes building wealth harder but financial independence is still achievable for thoughtful investors.

12 picks for an income portfolio - Q2 2026 update.Passive income growth continues to exceed my target.

4 income investing mistakes.Avoiding these mistakes will increase your chances of success as an income investor.

Can you retire on dividends?Living off of investment income addresses key risks faced by retirees. However, it introduces several considerations for investors who pursue this strategy.

You can find the transcript below:

Mark LaMonica: We’re going to talk about trade-offs today, Shani. And admittedly, trade-offs are no fun.

Shani Jayamanne: No, I only like decisions where there’s complete upside and just no consequences, really.

LaMonica: Exactly, exactly. And unfortunately, that isn’t true in life, and it certainly is not true in investing.

Jayamanne: So you recently wrote an article about trade-offs with income investing. And you started off the article with a quote, which also appears in our book. So you do like this quote. And people like quotes, so why don’t you start the podcast with it?

LaMonica: Okay. It’s from a novelist, an American novelist, James Salter. And the quote is for whatever we do, even whatever we do not do prevents us from doing its opposite. Acts demolish their alternatives. That is the paradox.

Jayamanne: So great quote. Tell us what it means.

LaMonica: Okay. Well, I think it captures this notion that we’re talking about with trade-offs, right? So, acts demolish their alternatives. So there are trade-offs for things that you do. And the biggest way to fail at investing is to assume that your choices don’t have any consequences.

Jayamanne: And we do talk a lot on this podcast about how there’s no right investment strategy or one right investment strategy. There can be many. But none of those strategies are perfect. And the key is finding the strategy where you can accept the flaws while the upsides align with your priorities in life.

LaMonica: We think this is really important because if you do find a strategy that aligns with what you want, it does make it more likely you will stick with that strategy over the long term and actually get the benefits from it.

Jayamanne: When we say flaws, what we actually mean is that there are certain periods of time where a strategy won’t do well. And it’s during those periods where investors get themselves into trouble.

LaMonica: And there’s a couple different ways that this happens. So the first way is just that natural tendency for people to chase performance. So all of us are naturally susceptible to that herding behavior. That’s a good technique for staying safe. If you are a caveman and you stick together, maybe that means staying alive longer. But today, I think people use this to try to be intellectually safe. So they only read viewpoints that they already agree with. They don’t want to be intellectually challenged. And of course, the downside to this is you can develop a false sense of confidence, and you’re, of course, unwilling to consider any other points, and that means you can become complacent.

Jayamanne: And this view is reinforced by the way that investment strategies and investment products are marketed. It isn’t a good marketing technique to point out the downside of an approach. So the apparent benefits are front and center while the risk is buried in the small print. In the product in the product disclosure statement.

LaMonica: Which you like reading. So maybe you’re the only one that actually knows the risks.

Jayamanne: Everyone does need a hobby Mark.

LaMonica: That is true.

Jayamanne: I’m trying to find a hobby at the moment. So if you have any ideas, send them into Mark’s email.

LaMonica: I thought it was photography.

Jayamanne: I don’t know. Not sold on it. But we’ll see.

LaMonica: You tried yoga.

Jayamanne: Nothing’s hidden. So let’s talk about trade-offs with income strategies, because that was obviously the topic of your article.

LaMonica: Okay. We’re going to start at a high level and we’ll drill into the data a little bit. So at a high level, dividend-paying shares tend to underperform during momentum-driven bull markets that underperformance typically becomes more acute during the really speculative phase, which is often just driven by hype.

Jayamanne: And there is a reason for this. Share prices are always being driven by expectations. That is true for all shares, but particularly for growth shares, because so much of their value lies far out into the future. Dividend shares are more about the near term than growth shares because you’re getting the dividend portion of the return right now.

LaMonica: Okay. Well, talk about how investors can get in trouble on both sides of that. So for growth shares, this typically happens from people who are overly optimistic about the future. So when their expectations get too high and frankly become unrealistic, growth investors get in trouble. For income investors, the problem comes from focusing too much on the current dividend and not thinking about what will happen to the company in the future.

Jayamanne: So we’ve talked a little bit about when an income share would underperform or an income strategy would underperform. How about when it outperforms?

LaMonica: That typically happens during periods of market stress. And it happens for a couple different reasons. So one is that dividends, of course, provide a source of returns in times where capital appreciation is either lower or potentially disappears altogether, and the share price is actually going down. So that is great. It also happens because of the nature of companies that pay dividends. So they typically are larger companies, they’re more mature, they are probably slower growing, but they’re in better financial shape, they’re less cyclical, and investors perceive them as safer during these time periods.

Jayamanne: And what strikes me about this is it shows how many investors are switching their strategies during different times. In some market conditions, they’re crowding into growth shares, and in some conditions, they’re crowding into dividend shares. And taking this view is what gets investors into trouble.

LaMonica: I think that it’s widely accepted that the way to be a good investor is to rotate your portfolio. And, that sounds really good in theory. It’s really, really difficult to do in practice. And the problem is that the timing matters. So you can’t rotate your portfolio after it is obvious to the whole market that conditions have changed because that’s actually too late. So if you spend all of your time trying to get that timing right of when to rotate your portfolio, you’re going to miss time it. Sometimes you might get lucky, most of the time you’ll probably miss time it and then your returns will suffer.

Jayamanne: Your returns will suffer because of transaction costs, but also because of taxes when you’re selling in and out. But let’s use a real world example and look at the market today.

LaMonica: Okay, so shouldn’t be news to anybody that there are a lot of companies out there benefiting from the build out in AI, and the market is trading at a historically high valuation, and that creates some risk. So let’s just assume that AI works out just like a lot of the optimistic people suspect. So adoption continues, companies find ways of monetizing it, and it creates those productivity gains that people are talking about. So this is sort of that golden scenario. Well, even if all of that happens, at some point, this initial AI infrastructure build out will come to an end. And that doesn’t mean that no more money will be spent on AI infrastructure, but after that initial build-out is complete, spending will plateau, and then it will reduce to a more normalized level.

Jayamanne: And I think even the most optimistic investors know that this will happen at some point. And there is a lot of discussion and debate about the timing. When it’s clear that spending has dropped, it will be too late to rotate out of AI stocks. So instead, investors have to look for signs. The risk is that you get out too early and you miss some strong returns. The risk is also that you get out too late and you suffer losses.

LaMonica: If you want to play that game, good luck. We do wish you the best. We think it’s really, really hard to do. Instead, what we would say is come up with a consistent strategy that’s aligned to your goals, and then just stick to it. And, me, for example, I do have some exposure to AI. But since I’m pursuing an income strategy, I also have a lot of exposure to companies that are impacted at all by AI. And I think, the trade-off is that when I chose that strategy, I knew there were times I would underperform, times like this, and then I know there’s also times that I’ll outperform, and that’s when that rotation happens out of some of these growth shares into income shares.

Jayamanne: And this is also why diversification is so important. Diversification throughout market cycles protects you from the full impact of these rotations.

LaMonica: That’s at a high level, kind of how income investing works. But we do want to dig a bit into the nuance, and we want to look at some underlying data for what is successful as part of an income strategy. All right, so we’re going to start with an annual report put out by a U.S. fund manager called Hartford Funds.

Jayamanne: And the study is called “The Power of Dividends: Past, Present, and Future”. And there’s a link to the study in Mark’s article, which we’ll link in the episode notes. The study breaks down S&P500 returns between 1973 and 2025 in several categories based on dividends. These categories are not mutually exclusive, so a share could be multiple categories.

LaMonica: Okay, so the categories are shares that grow dividends or initiate dividends, all companies that pay dividends, companies where the dividend stays consistent, and dividend non payers. The annual returns over the period, and these are the annual returns over that period, between 1973 and 2025. Dividend growers and initiators, 10.22% annual return. Dividend payers, 9.2% annual return. No change in dividend policy, 6.87% annual return. Dividend cutters and eliminators, negative 0.96% annual return, dividend non-payers, 4.21%. And if you compare all that to an equal weighted return of the S&P500, that was 7.74.

Jayamanne: And we’ll get to conclusions in a bit. But Mark tried to replicate part of this study and do it the same way for Australian shares. He looked at the ASX listed shares within our current coverage universe at Morningstar, which is 179 shares, and tried to put them in the same categories using returns over the last 10 years.

LaMonica: I did. And before I put people to sleep by reading out lots of numbers again, there are a couple caveats here. The first one is that I eliminated the category of no change in dividend policy. And I did that because only four companies that I looked at met that criteria. So it’s a really small sample size. But here we go. We’ll get to a couple more caveats in a second, but now I’ll read out the returns again. Dividend growers and initiators, 12.6% annual returns, dividend payers, 7.61% annual returns, dividend cutters and eliminators, 4.05% return, dividend non-payers, 9.8% return, and the equal weighted ASX 200, 8.70% return.

Jayamanne: And as you mentioned, there are a couple of more caveats. The first is that franking credits are included in those returns. The second is that there is survivorship bias and a natural bias towards companies that have done well that could have entered our coverage universe in the last decade. There are still some patterns between your efforts and the Hartford Fund study.

LaMonica: And the first one is companies that increase their dividends have significantly higher returns than the average company. And this illustrates the tendency of short-term noise or noise to drive the market over the short term, and then fundamentals influencing long-term outcomes. Growing dividends over the long term requires long-term earnings growth. These are the companies that rise above the competition and deliver for shareholders over the long term.

Jayamanne: And the lesson isn’t that dividend payer paying shares are inherently attractive. It is that companies that consistently raise their dividends tend to create shareholder value.

LaMonica: This study heavily influences my strategy. It’s been around for a long time. It’s just updated every year. So yes, I’m an income investor, but I’m looking for companies that grow their dividends. Now, that’s easy to say. It’s hard to do. We want to go through a couple tips to try to help investors do this.

Jayamanne: There’s more detail in Mark’s article, but the first tip is to find companies that have sustainable competitive advantages because that means that they can stand up to the competition. Think about the industry the company operates in and what drives customers from buying goods and services. If there are inherent advantages that certain companies possess in keeping those companies or winning new ones, it could be the sign of a moat.

LaMonica: All right. The next tip is look for predictability of future outcomes. So the more factors that are outside the control of management that can influence a company, the more likely it is that there’s a surprise. And those surprises, of course, can be on the upside or the downside. So this isn’t inherently bad to have a wide range of future outcomes. But for an income strategy, I’m looking for less of a surprise, so it’s more predictable for me.

Jayamanne: And valuations always matter. As an income investor, you can use current dividend yield versus historical dividend yields as a proxy. Remember the current dividend yield could be high for a reason, which could mean there could be it could be a dividend trap. You need to understand why the yield is high and look at the future prospects of the company.

LaMonica: And then we’re obviously trying to figure out dividend growth here, but it is worth focusing on sustainability just as kind of a minimum floor for what you’re looking for. So the payout rate, which is often the advice that you get. So the amount of earnings that are paid out in dividends doesn’t work that well in Australia because they’re typically really high. So if you’re looking for an Australian company, you can focus on the other factors. So that is companies that have a reasonable amount of debt for the type of company it is. It’s companies that do have a track record of making good investments in the business, which we can see from higher returns on invested capital. Basically, you want management that is a good steward of shareholder capital.

Jayamanne: And all investors need to remember that trade-offs matter and there is no free lunch in investing. Think through what those trade-offs are and remember there is no perfect investment. Instead, try and find the right investment and the right strategy for you.

LaMonica: Alright, great. Well, thank you guys very much for listening to our podcast about trade-offs. We appreciate it.

Invest Your Way

A message from Mark and Shani

For the past five years, we’ve released a weekly podcast and written on morningstar.com.au to arm you with the tools to invest successfully. We’ve always strived to provide independent, thoughtful analysis, backed by the work of hundreds of researchers and professionals at Morningstar.

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