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 should consider using an older investing technique—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.
Income investing is the practice of designing a portfolio of diversified investments to achieve a passive income to live on. These investments can include real estate, stocks, mutual funds, and bonds. It is important to consider which types of assets might be most valuable to someone who wanted to follow an income investing philosophy and understand the most common dangers that can affect an income investing portfolio
Income Investing Defined
The art of good income investing is putting together a collection of assets such as stocks, bonds, mutual funds, and real estate that will generate the highest possible annual income at the lowest possible risk. Most of this income is paid out to the investor so they can use it in their everyday lives to buy clothes, pay bills, take vacations, or whatever else they would like to do.
How the Social Unrest of the 20th Century Gave Birth to Income Investing
Despite some nostalgia for the 19th and early 20th centuries, society was quite messy. The mess was not from the lack of instant news, video chats, music-on-demand, 24-hour stores, and cars that could drive further than ten miles per gallon.
In that time-frame, if you were Jewish or Irish, most companies wouldn't hire you. If you were gay or lesbian, you were prescribed electroshock therapy; black men and women dealt with the constant threat of mob lynching and rape.
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. Add in the fact that there weren't any social security or company pension plans, resulting in most elderly people living in abject poverty.
What does all this have to do with income investing? Everything. These are the circumstances that caused the rise in income investing—when you peel back the layers, it's not difficult to understand how.
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 equivalent of $2,000 to $3,000 in 2020).
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 for 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.
These investments 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.
Today, we live in a world where women are just as likely to have a career as men, possibly making more money. If your husband 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, bank employee, and stockbroker needed to understand. No one refers to AT&T stocks as "a widow's stock" anymore, which should have been its second name a generation or two ago.
Today, with pension systems going the way of the dinosaur, and wildly fluctuating 401(k) balances plaguing most of the nation's working class, there has been a resurgence of interest in income investing.
How Much Cash Should I Expect From an Income Investing Portfolio?
The rule of thumb in income investing is if you never want to run out of money, you should take no more than 4% of your balance out each year for income. This is commonly referred to on Wall Street as the 4% rule. This is because if the market crashes, 5% has been shown in academic research to cause you to run out of money in as little as 20 years, whereas 3% did not.
Put another way, if you manage to save $350,000 by retirement at age 65 (which would only take $146 per month from the time you were 25 years old and earning 7% 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.
Multiple Income Stream Strategy
If you are an average, retired worker, in 2020 you will receive close to $1,500 per month in social security benefits. A couple, both receiving social security benefits, will average around $2,500. Add a $1,166 per month withdrawal from a pension fund, and you have a comfortable $3,666 per month income.
By the time you retire, you probably own your own home and have very little debt, so absent any major medical emergencies, you should be able to meet your basic needs. You could easily add another $500 to $600 per month to your monthly income by doing some part-time work.
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% and your investments earned 6% with 3% inflation, you would actually lose 5% 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 withdraw $500 to $600 per month (roughly $300 to $400 in 2020 dollars).
What Types of Investments Should I Hold in an Income Portfolio?
When you build your income investing portfolio you are going to have three major "buckets" of potential investments. These include:
- Dividend-Paying Stocks: Both common stocks and preferred stocks are useful. Companies that pay dividends pay a portion of annual profit to shareholders based on the number of shares they own. Try to choose companies that have safe dividend payout ratios, which means they distribute 40% to 50% of their annual profit and reinvest the remainder back into the business for growth. A dividend yield of 4% to 6% has generally been considered good for some time.
- Bonds: You have many choices when it comes to bonds. You can own government bonds, agency bonds, municipal bonds, savings bonds, or others. 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—the risk of bonds fluctuating wildly like stocks in response to changes in the Federal Reserve controlled interest rates.
- Real Estate: You can own rental properties 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. Many income investment portfolios have a heavy real estate component because its tangible nature creates lasting value. Psychologically, this provides a needed peace of mind to stick to a financial plan during fluctuating markets.
A closer look at each category can give you a better idea of appropriate investments for income investing portfolios.
What to Look for in Dividend Stocks for an Income Investing Portfolio
In your personal income investment portfolio, you'd want dividend stocks that have several characteristics. You'd want a dividend payout ratio of 50% 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. A dividend yield of between 2% and 6% is a healthy payout. 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 for the past three years, at a minimum. Income investing is about protecting and providing income, not swinging hard to hit the ball out of the park with risky stock picks.
Company History and Financial Performance
A proven track record of (slowly) 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, especially in mature businesses that don't have a lot of room to grow.
Other considerations are a business's return on equity (ROE—after-tax profit compared to shareholder equity), and its debt-to-equity ratio. Debt-to-equity is determined by dividing shareholder's equity by the amount of total debt a company has, revealing its ability to pay its obligations.
If a company can earn high returns on equity with a manageable debt-to-equity ratio (for its industry), it generally has a better-than-average financial model for income investors. This can provide a bigger cushion in a recession and help keep dividend checks flowing.
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 a personal preference.
The simplest income investing allocation would be:
- 1/3 of assets in dividend-paying stocks that meet previously stated criteria
- 1/3 of assets in bonds and/or bond funds that meet previously stated criteria
- 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. You could use this portion of your portfolio as a 50% down payment and borrow the rest so you can 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—again, this would only take $146 per month at 7% between the ages of 25 and 65. To keep the numbers simple, round up to the nearest $5 increment:
- Stocks: $108,335 invested in high-quality dividend stocks that have an average yield of 4.5%. Expected annual income: $4,875
- Bonds: $108,335 invested in high-quality bonds that have an average yield of 4.5%. Expected annual income: $4,875
- Real Estate: $108,335 used as 50% equity combined with another $108,335 borrowed from the bank to buy a total of $216,670 in property. After expenses, maintenance, costs, and vacancies, the expected annual income is $15,100.
- Grand Total Pre-Tax Income: $24,850 in cash. For sustainable income money, however, you should only take out 4% of the $350,000, or $14,000, so you would leave $10,850 in your income investing portfolio (an accounting professional should be consulted for tax consequences).
Bonds in an Income Investing Portfolio
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 slice of the business. The potential profit from bonds is much more limited; however, in the event of bankruptcy, you have a better chance of recouping your investment.
This is not to say that bonds are without risk. In fact, bonds have a unique set of risks for income investors. Your choices include bonds such as municipal bonds that offer tax advantages. A better choice may be bond funds, which are a basket of bonds, with money pooled from different investors—much like a mutual fund.
Bond Characteristics to Avoid
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 they can lose a lot of value if interest rates move sharply.
If you are trying to figure out the percentage your portfolio should have 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, then 30% of your portfolio should be in bonds. If you're 60, then 60% should be.
How Real Estate Might Help You Double the Withdrawal Rate
If you know what you’re doing, real estate can be a great investment for those who want to generate regular income (picture payments 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 is whether or not to buy a property outright or invest through a REIT. Both actions 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.
If you know your local market, can value a house, and have other income, cash savings, and reserves, you might be able to effectively double the amount of monthly income you could generate.
Why You Shouldn't Go All-In
If real estate offers higher returns for income investing, why not just put 100% of your investments into property?
This question is often asked when people see that they can double, or even triple the monthly cash flow they earn when buying property instead of stocks or bonds. There are three issues with this approach:
- If the real estate market falls, the loss is amplified by leverage; the use of debt to finance your real-estate purchases.
- 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
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 (how fast you might need to turn assets into cash).
Understanding the value of cash in a savings account cannot be overstressed. You should wait to begin investing until you have built up enough savings to allow you be comfortable about emergencies, health insurance, and expenses. Only then should investing be conducted.