Passive income might seem like a pipedream. Yet with time and dedication, it is possible. The key is income investing.
This post will explain what income investing is, explore the key things to consider when building your own income investing strategy, and provide seven different types of income investments.
What Is Income Investing?
All the different types of investors could be divided into two main groups: those who invest for capital gains and those who aim to generate income.
Their two respective investment objectives are known as growth and income.
Growth investing is focused on building a portfolio that grows over time through the continuous reinvestment of profits.
Tech stocks are the best-known example of growth. Most public tech companies don’t pay dividends because they still see lots of opportunities to reinvest in their businesses, either by creating new products or by acquiring younger startups.
By contrast, income investing is about building a portfolio that produces regular income.
This income should also be passive. While real estate and small businesses often generate regular income, those are not fully passive. Owners still need to put in some time, even if they have staff to manage day-to-day activities.
On the other hand, securities or paper investments are the only truly passive investments. Once you acquire those income investments, you don’t need to do anything. In fact, some income investors try to buy long-term stocks that they never plan on selling.
Who Are Income Investors?
Most income investors are retirees. In retirement, you want to enjoy a stable income and to reduce the impact of market volatility. One way to do this is by shifting from growth stocks to income investments.
Another group of income investors are people who have a large lump sum to invest — for example, from selling a business or receiving an inheritance. If that capital is enough to produce a meaningful income, it would be more reasonable to create an income portfolio instead of putting it in riskier investments.
How to Build Your Own Income Investing Strategy
The core idea in building an investment strategy is to prioritize regular and predictable cash flows over capital gains.
When developing your strategy, you should keep in mind three important things:
- What is your goal? The first step is to define what your goal is. Is it to withdraw a fixed sum every year? If so, you should remember not to withdraw more than the income your portfolio generates to avoid depleting the principle. One common rule of thumb is “the 4% rule,” which recommends never withdrawing more than 4% of your portfolio in any given year.
- What is your risk tolerance? Even with the safest investments, there is always some risk involved. You should think carefully about which risks you’re willing to take. For example, if you’re not planning to sell your asset, price volatility might not be an issue. Yet missed or lower dividends could be a major concern if you rely on that income.
- Is your portfolio diversified? Never put all your eggs in one basket. Even if you find a great opportunity with a high income, you should never invest more than 10% of your capital in it. Instead, spread your portfolio among several asset classes, ideally with uncorrelated returns. That way, if one of the assets underperforms, your other investments will cover the difference.
Now that we’ve got the basic idea of what to consider when building your income investing strategy, let’s review the core financial instruments you can use to build your income portfolio.
7 Types of Income Investments
Lots of investments produce income. We’ll review the main income investments, listing them in order from the safest ones to the riskiest ones. However, investors are paid to take on risks, so safer investments also have lower yields.
Which one of these seven types is the best?
None. Each investment has its own risks. It’s important to keep different kinds of assets in your portfolio to ensure adequate diversification.
1. Savings Accounts
Bank accounts and other savings accounts are classic examples of passive income investments. Most savings accounts are FDIC-insured up to $250,000. Even above this amount, savings accounts are relatively low risk.
The drawback is that interest rates paid by banks are now dismally low.
Annuities are contracts created by insurance companies that first collect funds and later make payments to the annuity holder. The annuity holder contributes funds during the initial accumulation phase, which may be as long as decades or as short as months.
The great thing about annuities is that payments are guaranteed. Although there are contracts with some variable payments, cash flows from annuities are typically more predictable than from market securities.
The main drawback of annuities is that you cannot sell them. Deposits are locked up in what is known as “surrender periods,” which could be years or decades. During this period, you can withdraw funds only with a hefty penalty that could be 10% or higher. That’s the main risk of annuities.
3. Fixed Income Investments
As the name suggests, fixed income securities pay a fixed income, either in the form of interest payments or final principal repayment on maturity.
This asset class includes a wide range of instruments:
- U.S. Treasuries bills, which are considered the safest investments
- Municipal bonds issued by local or state governments as well as government agencies to finance infrastructure
- Government bonds issued by countries
- Corporate bonds issued by companies, ranging from investment-grade to speculative high yield bonds, also known as “junk bonds”
Most bonds have minimum lots of $100,000 or higher. As a result, most retail investors cannot buy directly from bond issuers. Instead, most invest in bonds through mutual funds or exchange-traded funds (ETFs) that hold bond portfolios.
Unfortunately, bonds today don’t provide much income because the interest rates are at a 5,000-year low. Even the so-called “high yield” bonds, the riskiest section of the bond market, yielded 4% on average in August of 2021, compared to 6-9% just a few years ago.
For bonds, the main risk is the rise in interest rates. And when interest rates rise, bond prices fall. This is because when interest rates go up, investors prefer to buy the newer bonds with higher yields and sell older, lower-yielding bonds, pushing down their prices.
Meanwhile, defaults are relatively unlikely given that interest rates are so low that even the riskiest issuers can probably raise more debt to keep going.
Real Estate Investment Trusts, or REITs, are a special type of stock issued by companies that hold real estate. These stocks typically have lower volatility than other businesses because rent payments are more predictable than corporate earnings.
REITs are also known for high dividend yields. This is because REITs must maintain high dividend payout ratios to keep their special tax benefits.
5. Preferred Stocks
Preferred stocks could be thought of as something between common stocks and fixed income instruments.
Unlike common stock, preferred stocks do not grant voting rights. Yet preferred stocks have preferences in the order of dividend payments and in claiming assets in case of liquidations.
While dividends for preferred stock aren’t guaranteed, in practice, these payments are often fixed. Because of that, preferred stocks also typically have lower volatility than common stocks.
Preferred stocks, however, are subject to interest rate risk, just like fixed income securities.
6. Dividend-Paying Stocks
Another traditional source of portfolio income are dividend-paying stocks.
This broad category of stocks includes mostly mature companies that have established businesses with high cash flows. These businesses can well afford to pay dividends.
Instead of investing in individual stocks, some investors prefer to invest in dividend-focused ETFs. While this is easy to do, it can come at a cost of higher fees, which could add up.
For example, a ProShares S&P 500 Dividend Aristocrats ETF has an expense ratio (the fees) of 0.35%, which doesn’t look like much. Yet the ETF’s dividend yield is 1.9%. So expenses amount to about 18% of the dividend.
Writing (i.e., selling) options could also be another source of income. While writing naked options is very risky, writing covered calls or covered puts is a relatively low-risk strategy.
The main idea is that you collect the premium payment from option buyers. If that option expires worthless, there is nothing for you to do. And if your option is exercised, you sell a stock you already hold (for covered calls) or buy a stock with cash (for cash-secured puts). Many investors target 2% as the yield for writing options, but that’s not the limit.
Build Your Income Investment Portfolio
In this post, we’ve contrasted income investing to growth investing, reviewed the basics of building your own income investing strategy, and outlined several types of income investments.
However, as we’ve seen, building a retirement portfolio today is harder due to record low interest rates. In these market conditions, dividends become the main source of income. And if you want to find the best dividend stocks, subscribe to Investors Alley’s Dividend Hunter newsletter.