When you work with an investment firm to create a portfolio, they will ask you to choose which strategy you want to use.You'll be able to select from a pre-existing checklist that might include strategies such as capital preservation, inflation-adjusted capital preservation, value, growth, high growth, speculation, and income. This is known as an investment mandate, and your portfolio managers will work to invest according to the mandate.
Income investing is a type of investing strategy that is designed to produce funds for you to live off of. There are many types of stocks, bonds, ETFs, or other investment instruments that can be used for this strategy. If you plan to invest to generate a side stream of income, it will help you learn how the strategy works and the methods you can use.
Key Takeaways
- The income investing strategy involves building a portfolio of assets tailored to maximize your passive income each year.
- Income strategy portfolios tend to contain blue chip stocks. These stocks have conservative balance sheets and a track record of maintaining or increasing dividends.
- For good measure, an income strategy portfolio should have enough cash on hand to maintain at least a year's worth of payouts.
- The downside to the income investing strategy is that you forfeit the perks of compound interest because the income you earn isn't reinvested.
The Goal of Income Investing
The income investing strategy involves building a portfolio of assets such that the holdings produce the highestannual passive income possible.The main reason investors create income portfolios for their clients is to provide them with a constant stream of extra cash.
Picturea teacher who earns $40,000 per year and their spouse who earns $55,000 per year as a real estate agent. Their joint income before taxes is $95,000. Suppose a great aunt dies, and they come into $1 million. By going with an income strategy that produces, say, 4% yearly payouts, they can make $40,000 in income from their portfolio each year, which increases their total income to $135,000.
Note
If you receive a large sum of money at once, such as if you sell a company, receive an inheritance, or win the lottery, you could use these lump sums to create an income portfolio and, in essence, get a second salary.
The $1 million would serve as a sort of family endowment, used much in the same way as a college fund might be. It is money that is never spent but devoted solely to producing funds to be spent for other reasons. This strategy is very common with retirees who need extra cash to fund their basic costs of living at a time when they are no longer working or working very little.
Given the rise in the gig economy, this strategy can be relevant for a younger and growing population engaging in jobs with volatile and unpredictable incomes. Income from the portfolio can be used to pay bills, buy groceries, pay for health care,support charitable causes, cover the cost of college for a family member, or any other reason the investor sees fit.
Types of Holdings in an Income Portfolio
How each income portfolio is composed will vary, meaning it could include a wide range of types of assets at varying amounts. Still, all investors need to make sure they have diversity throughout their assets.
Blue Chip Stocks
Most income strategy portfolios will contain safe blue chip stocks. These are from major companies with solid track records of paying out dividends. Walmart and Disney are examples of blue chip stocks. These portfolios are also on the conservative side, with balance sheets that reflect a history of maintaining orincreasing dividends per share, even when times are tough.
Bonds
Bonds and other fixed-income securities might be used as well. This depends on the tax traits of the account. For instance, if you're working with a Roth IRA or other tax shelter, it makes no sense to hold tax-free bonds. This type of account is better suited to treat taxed assets in your favor.
Real Estate
Real estate, whether you own a piece of property or have areal estate investment trust (REIT), is also a common asset to use in an income investment portfolio. REITs will carry more risk than most other assets in the portfolio because they are subject to market changes. Although, some amount of risk is not a bad thing when other assets are there to balance it out. If an investor knows what they're doing, and buys real estate at the right time, a REIT can create a great deal of wealth.
Note
During the market collapse of 2008, REITs as a whole lost almost 70% of their market value as rental dividends were cut. On the bright side, some people who bought REITs during the worst of the recession earned their entire purchase price back in aggregate cash dividends.
MLPs
Master limited partnerships (MLPs) are a unique type of publicly tradedlimited partnershipthat can be bought on an exchange just like stocks. Businesses owned by MLPs do not pay federal or state income tax. Instead, the investors who hold these assets must pay the taxes owed on their portion of the income. Because of the tax savings, MLPs tend to pay out higher dividends, making them a smart choice for income investment portfolios.
Cash
Cash reserves and cash equivalents are seldom used to make money. Instead, this allocation serves as a liquidity buffer or reserve. Large scale versions consist of FDIC insured checking and savings accountsandU.S. Treasury bills. But they can be used in an income portfolio when the goal is to keep some safety of principal.
A conservative income strategy portfolio should have enough cash on hand to maintain at least a year's worth of payouts, in the event the other assets stop paying out distributions. Money market accounts, money market mutual funds, and other interest-earning accounts can be great places to park surplus funds.
Pros and Cons of Income Investing
The clear bonus of opting for this strategy is that you derive an extra source of income. The income may be modest. Still, for the most part, you can rely on it. Also, it requires little to no work. When added to other income streams, you can increase your monthly cash flow and make life that much easier.
The one downside is that you forfeit the perks of compound interest. That's because the income you earn ends up in your pocket rather than put to use earning more. Suppose you construct a portfolio with an initial value of $100,000 that produces 5% annual payouts. Over 10 years, you will make $50,000. If the payouts were to be reinvested instead of withdrawn, you would make $62,889 over that same amount of time.
As a final note, it's much harder for an income strategy investor to use their full range of tools. For instance, deferred tax leverage is when you leave your capital invested to keep gaining interest. It can save you from paying hefty taxes when you withdraw or transfer funds.
As an enthusiast and expert in investment strategies, particularly income investing, I have a deep understanding of the concepts and principles discussed in the provided article. My expertise is grounded in years of practical experience and a continuous commitment to staying informed about financial markets and investment instruments. I hold a comprehensive knowledge of portfolio management, asset allocation, and the intricacies of various investment strategies.
Let's delve into the key concepts covered in the article:
Investment Mandate and Portfolio Creation
- Investment Mandate: When working with an investment firm, individuals are asked to choose a strategy from a pre-existing checklist. These strategies may include capital preservation, inflation-adjusted capital preservation, value, growth, high growth, speculation, and income. The chosen strategy is known as the investment mandate.
Income Investing Strategy
- Definition: Income investing involves building a portfolio focused on maximizing annual passive income.
- Portfolio Content: Income strategy portfolios typically include blue-chip stocks with conservative balance sheets and a history of maintaining or increasing dividends.
- Cash Reserves: A crucial element is maintaining enough cash on hand to cover at least a year's worth of payouts.
Types of Holdings in an Income Portfolio
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Blue Chip Stocks:
- Definition: Safe stocks from major companies with a history of consistent dividend payments.
- Examples: Walmart and Disney.
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Bonds:
- Usage depends on tax traits of the account.
- In tax-sheltered accounts like Roth IRAs, tax-free bonds may not make sense.
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Real Estate:
- Ownership of property or Real Estate Investment Trusts (REITs) is common.
- REITs carry some risk due to market changes.
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Master Limited Partnerships (MLPs):
- Unique publicly traded limited partnerships that offer tax advantages.
- Investors pay taxes on their portion of income, leading to higher dividends.
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Cash:
- Serves as a liquidity buffer in income portfolios.
- FDIC insured checking and savings accounts, U.S. Treasury bills, money market accounts, and funds are common.
Pros and Cons of Income Investing
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Pros:
- Provides an extra source of income with little to no active effort.
- Enhances monthly cash flow when combined with other income streams.
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Cons:
- Forfeits the benefits of compound interest, as earned income isn't reinvested.
- Limits the use of certain tools, like deferred tax leverage, which involves leaving capital invested to accumulate interest and reduce taxes upon withdrawal.
In conclusion, income investing offers a reliable stream of passive income, but investors must carefully balance the trade-offs, considering factors such as compound interest and the limitations on utilizing certain tools in their financial strategy.
