10 Steps to Successful Income Investing for Beginners
Income investing could help you pay the bills
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.
In this special feature on income investing, you'll develop a better understanding of income investing, which types of assets might be considered appropriate for someone who wanted to follow an income investing philosophy and the most common dangers that can derail an otherwise successful income investing portfolio. At the very least, you will be armed with some things to consider before contacting a broker or money manager.
Income Investing Defined
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.
How the Social Unrest of the 20th Century Gave Birth to Income Investing
Despite the nostalgia for the 19th and 20th centuries, society was actually messy. I'm not talking about the lack of instant news, video chats, music-on-demand, 24-hour stores, and cars that could go more than ten miles per gallon.
No, I'm talking about the fact that if you were Jewish or Irish, most companies wouldn't hire you, if you were gay or lesbian, you were sent off to electroshock therapy, black men and women dealt with the constant threat of mob lynching and rape, people believed that all Catholics were controlled by the pope, and if you were a woman, you couldn't get a job doing anything more than typing, for which you would be paid a fraction of the amount offered to a man for similar work. Oh, and there wasn't social security or company pension plans, resulting in most elderly people living in abject poverty.
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.
The Rise of Income Investing
For everyone except for well-connected white men, the decent paying labor markets were effectively closed. One notable exception: 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 (and nearly impossible because commissions could run you as high as $200 or $300 per trade in the 1950s).
The Widow's Portfolio Bursts Onto the Scene
These social realities meant that women, in particular, were regarded by society as helpless without a man. Up until the 1980s, you would often hear people discussing a portfolio designed for income investing as a "widow's portfolio." This was because it was a fairly routine job of officers in the trust department of community banks to take the life insurance money a widow received following her husband's death and put together a collection of stocks, bonds, and other assets, that would generate enough monthly income for her to pay the bills, keep the house, and raise the children without a breadwinner in the home. Her goal, in other words, was not to get rich but to do everything possible to maintain a certain level of income that must be kept safe.
This whole notion seems bizarre to us. We live in a world where women are just as likely to have a career as men, and if they do, they may very well make more money. If your spouse died in the 1950s, however, you had almost no chance of replacing the full value of his income for your family. That's why income investing was such an important discipline that every trust officer, a bank employee, and stockbroker needed to understand. Those days are gone. After all, when was the last time you heard AT&T referred to as "a widow's stock," which could have very well been its second name a generation or two ago.
Today, with the pension system going the way of the dinosaur and the wildly fluctuating 401(k) balances plaguing most of the nation's working class, there has been a surge of interest in income investing and how you can structure your assets to bring in passive income. Next, you'll have to choose which assets are right for you.
How Much Cash Should I Expect From an Income Investing Portfolio?
The 4 Percent Rule
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.
Not Running out of Money
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.
What Types of Investments Should I Hold in an Income Portfolio?
3 Types of Investments to Consider
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 Reserve 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.
Let's look at each category closer to get a better idea of appropriate investments for income investing portfolios.
What to Look for in Dividend Stocks for an Income Investing Portfolio
Positive Characteristics of Dividend Stocks
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 in an Income Investing Portfolio
Characteristics of Bonds to Consider or Avoid
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 bonds 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 - which, according to Burton Malkiel, famed author of A Random Walk Down Wall Street and respected Ivy League educator, is your age. If you're 30, 30 percent of your portfolio should be in bonds. If you're 60, 60 percent.
How Real Estate Might Help You Double the Withdrawal Rate
I know that I gave real estate a hard time in The Great Real Estate Myth, but the truth is, if you know what you’re doing, real estate can be a great investment for those who want to generate regular income (picture rent checks just rolling in each month). That’s especially true if you are looking for passive income that would fit into your income investing portfolio.
Your main choice will come down to whether or not to buy a property outright or invest through a REIT, which is short for real estate investment trust. Both have their own advantages and disadvantages, but they can each have a place in a well-built investment portfolio.
A Major Advantage of Real Estate
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.
3 Reasons Not to Put All Your Money in Real Estate
- If the real estate market falls, the loss is amplified by leverage.
- Real estate requires more work than stocks and bonds due to lawsuits, maintenance, taxes, insurance, and more.
- On an inflation-adjusted basis, the long-term growth in stock values has always beat real estate.
The Role of Saving in an Income Investing Portfolio
Saving is Vital
Remember that saving money and investing money are different. Even if you have a broadly diversified income investing portfolio that generates lots of cash each month, it is vital that you have enough savings on hand in risk-free FDIC insured bank accounts in case of an emergency. The amount of cash you require is going to depend on the total fixed payments you have, your debt levels, your health, and your liquidity outlook.
To begin understanding this, you may want to start with saving vs. investing and then follow up with How much should I be saving? to fully appreciate the importance of a savings plan in addition to your cash generating portfolio.
Don’t forget to consider health insurance and the role it plays in your financial decisions when it comes to saving.
What Allocation Should I Consider for My Income Investing Portfolio?
What percentage of your income investing portfolio should be divided among these asset classes (stocks, bonds, real estate, etc.)? The answer comes down to your personal choices, preferences, risk tolerance, and whether or not you can tolerate a lot of volatility. Asset allocation is personal.
The simplest income investing allocation would be:
- 1/3 of assets in dividend-paying stocks that meet the criteria we discussed.
- 1/3 of assets in bonds and/or bond funds that meet the conditions we discussed.
- 1/3 of assets in real estate, most likely in the form of direct property ownership through a limited liability company or other legal structure to protect you if you are sued. You can use this portion of your portfolio as a 50-percent down payment and borrow the rest on top so you can actually own double the real estate.
A Look at the Numbers in Detail
What would this allocation look like in a real portfolio? Let's take a look at a worker who retires with $350,000 because, again, this would only take $146 per month at 7% from the time you were 25 until you were 65. To keep the numbers simple, I'm going to round up to the nearest $5 increment.
Stocks: $108,335 invested in high-quality dividend stocks that have an average yield of 4.5 percent. Expected annual income: $4,875
Bonds: $108,335 invested in high-quality bonds that have an average yield of 4.5 percent. Expected annual income: $4,875
Real Estate: $108,335 used as 50 percent equity combined with another $108,335 borrowed from the bank to buy a total of $216,670 in property. After expenses, maintenance, costs, vacancies, et cetera, expected annual income: $15,100.
Grand Total Pre-Tax Income: $24,850 in cash. For sustainable money, however, you should only take out 4 percent of the $350,000, or $14,000, so you would leave $10,850 in your income investing portfolio (please talk to your accounting professionals to understand any tax consequences of this income). This setup should last you forever.