Do you need to build a portfolio that will generate cash? Are you more concerned with paying your bills and having enough income than growing richer? If so,you need to focus on something called income Investing.
This long-lost practice used to be popular before the great twenty-year bull market taught everyone to believe that the only good investment was one that you bought for $10 and sold for $20. Although income investing went out of style with the general public, the discipline is still quietly practiced throughout the mahogany-paneled offices of the most respected wealth management firms in the world.
Let’s define income investing precisely so you know exactly what it is. The art of good income investing is putting together a collection of assets such as stocks, bonds, mutual funds, and real estate that generates the highest possible annual income at the lowest possible risk. Most of this income is paid out to the investor so he or she can use it in their everyday lives to buy clothes, pay the mortgage, take vacations, cover living expenses, give to charity, or whatever else they desire.
What does that have to do with income investing? Everything. These are the circumstances that caused the rise in income investing and when you look a bit deeper, it’s not difficult to understand why.
If you owned stocks and bonds of companies such as Coca-Cola or PepsiCo, these investments had no idea if you were black, white, male female, young, elderly, educated, employed, attractive, short, tall, thin, fat—it didn’t matter. You were sent dividends and interest throughout the year based on the total size of your investment and how well the company did. That’s why it became a near-ironclad rule that once you had money, you saved it and the only acceptable investing philosophy was income investing. The idea of trading stocks would have been anathema.
The rule of thumb for income investing is that if you never want to run out of money, you take 4 percent of your account balance out each year. This is commonly referred to on Wall Street as the 4 percent rule. (Why 4%, you ask? If the market crashes, 5 percent has been shown in academic research to cause you to run out of money in as little as 20 years, whereas 3% virtually never did.)
Put another way, if you manage to save $350,000 by retirement at 65 years old (which would only take $146 per month from the time you were 25 years old and earning 7 percent per year), you should be able to make annual withdrawals of $14,000 without ever running out of money. That works out to a self-made pension fund of roughly $1,166 per month pre-tax.
If you are the average retired worker, in 2019 you will receive $2,861 in social security benefits. Add the two together and you have a monthly cash income of $4,027, or $48,324 per year. All else being equal, an income investing portfolio structured this way wouldn’t run out of money, whether you lived to 67 or 110 years old. By the time you retire, you probably own your own home and have very little debt, so absent any major medical emergencies, that should allow you to meet your basic needs. You could easily add another $5,000 or $6,000 to your annual income by doing part-time work in the community.
If you’re willing to risk running out of money sooner, you can adjust your withdrawal rate. If you doubled your withdrawal rate to 8 percent and your investments earned 6 percent with 3 percent inflation, you would actually lose 5 percent of the account value annually in real terms. This would be exaggerated if the market collapsed and you were forced to sell investments when stocks and bonds were low. Within 20 years, however, you would only be able to withdrawal $500 to $600 per month at a time when that represented the same as only $300 today.
When you put together your income investing portfolio you are going to have three major “buckets” of potential investments. These are:
Dividend Paying Stocks: This includes both common stocks and preferred stocks. These companies mail checks for a portion of the profit to shareholders based on the number of shares they own. You want to choose companies that have safe dividend payout ratios, meaning they only distribute 40 percent to 50 percent of annual profit, reinvesting the rest back into the business to keep it growing. In today’s market, a dividend yield of 4 percent to 6 percent is generally considered good.
Bonds: Your choices when it comes to bonds are vast. You can own government bonds, agency bonds, municipal bonds, savings bonds, and more. Whether you buy corporate or municipal bonds depends on your personal taxable equivalent yield. You shouldn’t buy bonds with maturities of longer than 5 to 8 years because you face duration risk, which means the bonds can fluctuate wildly like stocks in response to changes in the Federal Reserves controlled interest rates.
Real Estate: You can own a rental property outright or invest through REITs. Real estate has its own tax rules and some people are more comfortable with it because it naturally protects you against high inflation. Many income investment portfolios have a heavy real estate component because the tangible nature lets those living on an income investing portfolio drive by the property, see that it still exists, and reassure themselves that even if the market has fallen, they still own the deed. Psychologically, that can give them the needed peace of mind to hang on and stick to their financial plan during turbulent times.
In our personal income investment portfolios, we would want dividend stocks that had several characteristics such as:
- A dividend payout ratio of 50 percent or less with the rest going back into the company’s business for future growth.If a business pays out too much of its profit, it can hurt the firm’s competitive position. According to some academic research, a lot of the credit crisis that occurred between 2007 to 2009 and changed Wall Street forever could have been avoided if banks had lowered their dividend payout ratios.
- A dividend yield of between 2 percent and 6 percent.That means if a company has a $30 stock price, it pays annual cash dividends of between $0.60 and $1.80 per share.
- The company should have generated positive earnings with no losses every year for the past three years, at a minimum. Income investing is about protecting your money, not hitting the ball out of the park with risky stock picks.
- A proven track record of increasing dividends. If management is shareholder-friendly, it will be more interested in returning excess cash to stockholders than expanding the empire, especially in mature businesses that don’t have a lot of room to grow.
- A high return on equity, or ROE, with little or no corporate debt.If a company can earn high returns on equity with little or no debt, it usually has a better-than-average business. This can provide a bigger cushion in a recession and help keep the dividend checks flowing.
Bonds are often considered the cornerstone of income investing because they generally fluctuate much less than stocks. With a bond, you are lending money to the company or government that issues it. With a stock, you own a piece of a business. The potential profit from bonds are much more limited but in the event of bankruptcy, you have a better chance of recouping your investment.
That’s not to say bonds are without risk. In fact, bonds have a unique set of risks for income investors. Here’s what we would be looking for if we were putting together an income investing portfolio with bonds:
- Your choices include bonds such as municipal bonds that offer tax advantages. A better choice may be bond funds, which you can learn all about in bond vs bond funds. You can learn more by reading tests of safety for municipal bonds, which will explain some of the things you may want to look for when you are choosing individual bonds for your portfolio.
- One of the biggest risks is something called bond duration. When putting together an income investing portfolio, you typically shouldn’t buy bonds that mature in more than 5-8 years because changes they can lose a lot of value if interest rates move sharply.
- You should also consider avoiding foreign bonds because they pose some real risks unless you understand currencies.
- If you are trying to figure out the percentage of your portfolio to invest in bonds, you can follow the age old rule, is your age. If you’re 30, 30 percent of your portfolio should be in bonds. If you’re 60, 60 percent.
One major advantage of real estate is that if you are comfortable using debt, you can drastically increase your withdrawal rate because the property itself will keep pace with inflation. This method is not without risk but for those who know their local market, can value a house, and have other income, cash savings, and reserves to protect them if the property is vacant for an extended period of time or loses value, you might be able to effectively double the amount of monthly income you could generate.
If real estate offers higher returns for income investing, why not just put 100 percent in property?
This question is often asked when people see that they can double, or even triple the monthly cash flow they earn by buying property instead of stocks or bonds, using bank mortgages to acquire more houses, apartments, or land than they could otherwise afford.