Generally, stock investors are interested in two things: growth and income. Younger investors with many years between them and retirement will seek growth stocks to build wealth over time. Investors nearing retirement, on the other hand, have different objectives. These investors are seeking income stocks to generate passive income for retirement.
With pension plans disappearing and 401(k) plans at the mercy of market volatility, today’s investors are increasingly finding income stocks attractive.
When you retire, you’ll be depending on a steady flow of income to replace what you had been making while you were working. Retirees or those approaching retirement must design a plan to generate enough of that income after leaving the workforce to ensure the investor doesn’t outlive their income stream.
But let’s be clear: Although income investing is popular with retirees, retirees are not the only segment of the population looking to benefit from this investing strategy. Income investing is a lucrative play for any investor looking for an additional stream of income.
This article will help burgeoning income investors better understand income stock, the benefits of income investing, and what to look for in an income stock to help create a financially secure and stress-free retirement.
What Are Income Stocks?
As their name implies, income stocks generate income.
Income stocks pay passive income that you can reinvest now when you don’t need it and live on later in retirement when you are no longer working.
The income comes in the form of interest and dividends. But dividend stocks are the real money maker, especially in a low interest rate environment. Dividend stocks can generate much higher income than many fixed-income investments.
Dividend payments are a company’s way of sharing profits with their investors. Dividend payouts are typically cash payments that companies distribute to their investors on a regular basis. Most companies pay quarterly dividends, though some pay annually, semi-annually, or monthly.
Unlike growth stocks, which investors buy hoping that the share price will increase, inventors buy income stocks to earn — you guessed it — income.
Benefits of Income Stocks
Investors with income stocks that pay regular dividends are not at the mercy of the stock market. Why? Because with income stocks, even if the stock price of your income stock falters, that company still pays your dividend.
Investing in the stock market can certainly build a strong foundation for a comfortable retirement. But to reinforce that foundation, your portfolio will need investments that not only have upside potential when it comes to stock price, but also generate a predictable income stream.
A retirement portfolio that has the right income stocks can provide you exactly that — a predictable income stream of dividend income you can count on.
Plus, that income has potential to grow over time since many dividend stocks grow their payouts, which preserves the purchasing power of dividends when they’re reinvested.
And dividend stocks, like other equities, also provide meaningful long-term price appreciation potential. So even though you’ll be getting the benefits from your dividends, don’t forget that the growth of the stock will benefit your retirement portfolio as well.
Buy and Hold vs. Buy Low, Sell High
Many investors only think “buy low, sell high” when they enter the stock market. While this investment strategy can certainly pay off, there is a significant amount of uncertainty and volatility involved in the stock market.
Income stocks help make the market just a little more reliable because they represent the “buy and hold” strategy that investment guru Warren Buffett loves so much.
The Apple Orchard Analogy
We like to use an analogy of an apple orchard when demonstrating the benefit of income stocks.
When those growth investors “sell high” they essentially eliminate all potential future benefits of that stock.
Imagine the apple farmer chopping down all those beautiful apple trees at harvest time rather than just harvesting the fruit and continuing to generate income by selling it and letting those trees produce more in the future.
Income stocks, on the other hand, keeps your initial investment untouched. It’s there for future generations and, maybe even more importantly, it’s still generating passive income that could have enormous growth potential depending on how long you can ride out this strategy.
How to Add Income Stocks to Your Investment Portfolio
Designing a high-performing retirement portfolio is an artform. In a piece of art, you need the right colors and the right combination of colors.
In your retirement portfolio, those colors are your investment choices. Solid income investing means you’ve compiled income assets like stocks, bonds, mutual funds, real estate, and real-estate investment trusts, or REITs, that will generate the highest annual income with the lowest amount of risk.
Income stocks can be found in any industry. You’ll find stocks that pay dividends in real estate, healthcare, and many blue-chip stocks.
It’s always a good idea to consider which types of investments will best suit your needs. Think about your passive-income goals and your specific investing philosophy as well as your risk tolerance.
Let’s review different types of investment instruments you can leverage to secure income stock:
- Individual stocks (common shares): Stocks issued by companies that pay dividends provide shareholders the right to vote and own a stake in the company.
- Preferred shares: Companies issue preferred shares to borrow the capital that investors spend purchasing the shares. Essentially, the company issues preferred shares, pays dividends, and stockholders, in turn, benefit from higher yields than are paid by common shares.
- Mutual funds: Many mutual funds focus on generating income by purchasing high-dividend stocks and high-coupon bonds to ensure high-yield.
- Exchange-traded funds (ETFs): ETFs track the performance of a certain index, sector, commodity, or a mix of other securities. Some ETFs focus on dividend-paying stocks and some provide the option to reinvest. For example, the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) is an ETF that tracks the S&P 500 Index. This means it follows the performance of the 500 largest publicly traded companies like Amazon and Microsoft.
- Closed-end funds (CEFs): CEFs seek out the best additions to an existing portfolio and strive to achieve the highest dividend yield possible while minimizing risk. Fund managers actively manage CEFs.
What to Look for in an Income Stock
You’re looking for income stocks that have safe dividends based on the underlying company’s ability to sustain itself and generate cash flow over time. A yield somewhere between 2% and 6% is also a good sign. Then, of course, you’ll want to do your due diligence to ensure that the company has the ability and potential to continue growing their dividend payouts in the long term.
Sound like a tall order? It is. That’s why this isn’t a get-rich-quick scheme. You need to know what you’re doing.
How Strong Is the Company?
Dividend stock payments are on a per-share basis and depend on how profitable the company is at the current time. This strength comes from many factors. The management team is one of the most important factors to understand.
The investor always hopes that the stock price will appreciate over time. But since dividend stocks provide income in the form of dividend payouts, you’re essentially offsetting risk in times of market volatility.
So, if the stock price plummets one day because of something beyond the company’s control, like a global pandemic, you want to be confident that the management team at the company you’ve invested in has the chops to weather the storm. This way, you’re in no rush to cut down your apple trees by selling your shares.
Is the Yield Sustainable?
You can calculate a stock’s dividend yield by dividing total annual dividend payments by the stock price.
For example, let’s consider a stock that pays a quarterly dividend of 25 cents, produces $1 in annual payments, and is trading for $20 per share. We divide $1 by $20 and the dividend yield is 5%.
The best dividend stocks have yields of 4% or more. However, investors should be skeptical of any unusually high dividend yields. If a dividend yield appears too good to be true, it usually is.
A dividend yield that feels too high or appears unrealistic could be an indicator that:
- The stock price has recently dipped.
- The company is stretched too thin and is paying out dividends that don’t make sense in relation to its balance sheet and debt levels.
Investors typically view dividend yields between 2% and 6% as healthy. But of course, some dividend stocks with higher payouts are legitimate money makers.
Can the Company Sustain Dividend Growth?
It’s often said that past performance does not guarantee future results. This statement is typically true. However, there is a group of stocks that seem to be bucking the trend.
The Dividend Aristocrats are a group of well-known individual companies that pay dividends. They’re also cash-generating companies with unusually solid track records. To join the list, the company must have a market value above $3 billion and must also have increased their dividend payments in the last 25-plus consecutive years — even in spite of market volatility.
This means that Dividend Aristocrats are effectively giving their investors “pay raises” in the good times and the bad.
When it comes to due diligence, checking in with the Dividend Aristocrats is always a good place to start. The list is maintained by S&P Indices, which has done a lot of the vetting for you.
Setting Yourself Up for Success
Make no mistake. With income stocks, you’re not focusing on the short-term. Income stocks are long-term investments. If you follow the advice in this article, you’ll find the best stocks to generate income for your retirement.