Do you need to build a portfolio that will generate cash? Are you worried about paying your bills and having enough income right now and need an extra income stream? If so, you should consider using an old investment technique – income investing.
Income investing is the practice of designing a portfolio of investments that will give you passive income that you can live on. Investments can include real estate, stocks, mutual funds and bonds.
It’s important to consider what types of assets will enable you to meet your passive-income goals and investment philosophy while understanding some of the common risks that can affect an income investment portfolio.
What is income investing?
The art of good income investing is the accumulation of assets such as stocks, bonds, mutual funds and real estate that will generate the highest potential annual income at the lowest possible risk. Most of this income is paid to the investor so that they can use it in their daily life to buy clothes, pay bills, go on vacations and live a good life without worrying about money.
Naturally, income investing is popular with people at or near retirement. When you retire, you rely on a steady stream of income to replace the income you had while you were in the labor force. Today, with pension systems going the way of the dinosaurs and 401(k) holders intimidated by fluctuating balances, there has been a resurgence of interest in income investing. In 2020, the amount of money flowing into 401(k)s was the highest since 2008.
Finding a monthly income target for your portfolio
To find the monthly income you need to generate your investment strategy, you will be primarily concerned with your withdrawal rate, which is how much income you withdraw from your investments each year.
The rule of thumb in income investing is if you never want to run out of money. You should not withdraw more than 4% of your balance per year for income. This is commonly referred to as the 4% rule on Wall Street. 3
Put another way, if you manage to save $350,000 by retirement at age 65 (which would take just $146 per month since you were 25 and earn 7% per year), you’ll be able to make annual withdrawals of $14,000 for free. Never run out of money.
If you are the average retired worker, you will receive about $1,500 per month in Social Security benefits. A couple with both people receiving Social Security benefits would average $2,500. Add $1,166 per month from investments and you have a comfortable income of $3,666 per month.
By the time you retire, you’ll probably own your own home and have very little debt. In the absence of any major medical emergency, you should be able to meet your basic needs. If you are willing to risk running out of money early, you can adjust your withdrawal rate.
If you double your withdrawal rate to 8% and your investments earn 6% with 3% inflation, you lose 5% of the account value annually in real terms.
Key investments for your income investment portfolio
When you create your portfolio of income investments, you will have three main “buckets” of potential investments. This includes:
- Dividend Paying Stocks : Both common stocks and preferred stocks are useful. Companies that pay dividends pay a portion of annual profits to shareholders based on the number of shares they own.
- Bonds: You have many choices when it comes to bonds. You can own government bonds, agency bonds, municipal bonds, savings bonds, or others.
- Real Estate : You can own a rental property outright or invest through real estate investment trusts (REITs). Real estate has its own tax rules, and some people are more comfortable because real estate offers some protection against high inflation.
A closer look at each category can give you a better idea of the right investments for an income investment portfolio.
Dividend stocks in an income investment portfolio
In your personal income investment portfolio, you want dividend stocks that have many characteristics.
- Dividend payout ratio: You want a dividend payout ratio of 50% or less , with the rest going back into the company’s business for future growth.
- Dividend yield : If a business pays out too much of its profits, it can harm the firm’s competitive position. A dividend yield of between 2% and 6% is a healthy payout. 6
- Earnings : The company should generate positive earnings for at least the last three years with no losses.
- Track record: A proven track record of gradually increasing dividends is also preferred. If management is shareholder-friendly, it will be more interested in returning excess cash to stockholders than expanding the empire.
- Ratios : Other considerations are the business’s return on equity (also called ROE, profit after taxes relative to shareholder’s equity) and its debt-to-equity ratio. ROE and debt-to-equity should be healthy when compared to industry peers. This can provide a big cushion in a downturn and help keep dividend checks flowing.
Bonds in an income investment portfolio
Bonds are often considered a staple of income investing because they typically fluctuate much less than stocks. With a bond, you are lending money to the company or government that issues it. With stock, you own a part of the business. Potential profits from bonds are more limited; However, in the event of bankruptcy, you have a better chance of recovering your investment.
Your choices include bonds like municipal bonds that offer tax benefits. A better choice may be a bond fund, which is a basket of bonds that pool money from different investors – such as a mutual fund.
Here are some bond characteristics you’ll want to avoid:
- Long Bond Duration : One of the biggest risks is called bond duration. When putting together an income investment portfolio, you should generally not buy bonds that mature in more than eight years because they can lose a lot of value if interest rates move quickly.
- Risky Foreign Bonds : You should also consider avoiding foreign bonds as they pose some real risks unless you understand the fluctuating currency market.
If you’re trying to figure out what percentage of your portfolio should be in bonds, you can follow an age-old rule of thumb, according to Burton Malkiel, the acclaimed author of “A Random Walk Down Wall Street” and respected Ivy League educator. your age. If you are 30 years old, 30% of your portfolio should be in bonds; If you are 60, it should be 60%.
Real estate in an income investment portfolio
If you know what you’re doing, real estate can be a great investment for those looking to generate regular income. That’s especially true if you’re looking for passive income that will fit into your income investment portfolio.
Your main choice is whether to buy the property outright or invest through a real estate investment trust (REIT). Both actions have their advantages and disadvantages, but they can each find a place in a well-constructed investment portfolio.
This method is not without risk, and you should not simply put 100% of your investment into property. There are three issues with this approach:
- If the real estate market declines, using debt to finance your real estate purchase increases losses through leverage.
- Real estate requires more work than stocks and bonds due to litigation, maintenance, taxes, insurance and more.
- On an inflation-adjusted basis, long-term growth in stock values has always outpaced real estate.
Allocating your investments for income
What percentage of your income investment portfolio should be divided into stocks, bonds, real estate, etc.? The answer comes down to your personal preferences, preferences, risk tolerance and whether or not you can tolerate a lot of volatility. Asset allocation is a personal choice.
The simplest income investment allocation can be:
- One-third of assets in dividend-paying stocks that meet the previously stated criteria
- One-third of the assets in bonds and/or bond funds that meet the previously stated criteria
- One-third of assets in real estate, mostly in the form of direct property ownership through a limited liability company or other legal structure.
Although simple, this example allocation may not be best for you personally. If you are young and willing to take risks, you can allocate more of your portfolio towards stocks and real estate. The higher risk you take can potentially lead to higher rewards.
If you are risk averse, you may want to allocate more of your portfolio to bonds. They are less risky and consequently pay less. One-size-fits-all portfolios are not.
The role of savings in an income investment portfolio
Saving money and investing money are different, although they both serve your overall financial plan. Even if you have a portfolio of diversified income investments that generate a lot of cash each month, you still need to have enough savings in risk-free FDIC-insured bank accounts in case of an emergency.
Funds saved in a bank account are liquid and can be withdrawn quickly when needed. When all your funds are invested, your capital is tied up, and you may be forced to exit positions to cash out. Doing so can negatively impact your return and tax efficiency.
How much cash you need will depend on the total fixed payments you have, your debt level, your health, and how quickly you may need to turn assets into cash.
Understanding the value of cash in a savings account cannot be overemphasized. You should wait to start investing until you have saved enough to be comfortable with emergencies, health insurance and expenses. Only then should you start investing.