Portfolio income might sound like something that’s only relevant to portfolio managers or other finance professionals. Yet it simply means “income from investments” and is crucial for anybody planning for retirement or other financial goals.
In this article, we’ll dive into what portfolio income is, its main sources, the importance of diversification, and other key things to keep in mind when building a portfolio.
What Is Portfolio Income?
First, let’s get clear on what a portfolio is.
A portfolio is a collection of all your investments, including bonds, stocks, cash, certificates of deposit, and other financial instruments.
Portfolio income is the return from all investments in the portfolio. That’s why it’s also known as investment income.
Real estate might also be considered part of your portfolio, yet it’s a bit more complicated. Managing rental properties could grow into a full-blown business that requires a physical presence on the ground. It’s not a purely passive income where you simply collect the checks while relaxing on the beach.
Some portfolios might also include precious metals, art, and even rare wine collections. These alternative investments usually don’t have any cash flow (although they might have some costs). Yet they can rise in price and that would generate some portfolio income through capital gains.
So to sum up, portfolio income is the total return that consists of:
- Cash flows from investments — for example, interest payments or dividends
- Capital gains from price appreciation
Now let’s dig deeper into what investments can provide this sought-after portfolio income.
Sources of Portfolio Income
As we saw, portfolio income includes both cash flow and income from capital gains. That’s because you can sell your winners and spend or reinvest those gains.
We can break down different sources of portfolio income from the most certain (safe or least risky) to the least certain (risky):
- Interest income: Savings accounts and bonds are safe investments with guaranteed or nearly guaranteed cash flows.
- Dividend income: Some stocks pay dividends, although there are no guarantees.
- Income from financial strategies: For example, writing (i.e., selling) options for stocks from your portfolio could generate income, although it comes with additional risks.
- Capital gains: Price appreciation of individual stocks, mutual funds, real estate, and other investments is never guaranteed and depends on the market.
As you probably know, there is a direct connection between risk and return. The safest assets (low or no risk) also have the lowest returns. And to generate a decent return, you must take on risks — for example, the risks of default for bonds or dividend cancellation for stocks. And for any asset that you hope will go up in price (generate capital gains), you should expect the risks of price volatility.
Now let’s look at the main income investments that fall into each of these categories.
Investments that pay interest are also known as fixed income.
Arranging these instruments from least risky to most risky, this category includes:
- Savings accounts, certificates of deposit, and money market accounts
- Government and municipal bonds
- Corporate bonds from high-quality issuers (i.e., companies graded by rating agencies)
- High-yield or junk bonds from companies with risks of default
Historically, bonds were the main source of portfolio income for retirees and institutional investors alike.
Yet now that interest rates across the world are at record lows, even high-risk junk bonds rarely yield double-digit returns.
As a result, dividends are now an increasingly important part of portfolio income.
This category includes primarily:
- Dividend stocks: These are usually mature companies that have histories of consistent dividends. This also includes the Dividend Aristocrats, or companies that have paid growing dividends for over 25 years.
- REITs: Real Estate investment trusts are a special type of stocks. They pay high dividends and have relatively stable valuations because they hold and operate real estate portfolios.
Dividend yields can vary drastically. They could be anywhere from under 1% to double digits. However, remember about risk and return. A high dividend yield could be a sign of some fundamental problems with the stock.
Income From Options
While there are lots of investment strategies that leverage portfolios to generate income, the most common one is writing (i.e., selling or issuing) options for stocks.
When you sell a new option, you collect the premium from the buyer. If the option holder executes the option, you’ll need to buy (for put options) or sell (for call options) the stock. However, most options are never executed.
If you already have sizable positions in some stocks and want to buy or sell stocks at specified prices, you can use options to achieve these goals while generating additional income:
- Writing covered calls: This involves selling call options for stocks that you already own. Imagine, for example, that you own Tesla (NASDAQ:TSLA) shares. They’re currently worth $685 per share, and you’d sell if the price increased to $800 per share. You can sell a call option with a strike price of $800 and collect a premium from the option buyer. If the share price rises to the strike price, you’ll sell Tesla to cover the call, just as you planned. And if it doesn’t, the option expires worthless, so you simply keep the premium as your additional income.
- Writing puts to buy: if you would like to buy shares at a lower price and have money earmarked for that, you can sell put options. Using Tesla as an example, if you think it would be a great bargain at $550 per share, you can sell a put option with that strike price. Then, if the price falls to that level, your put will be exercised, and you’ll buy shares from the holder of the option. And if options expire worthless, you’ll still keep the premium.
You should use these and other advanced strategies only if you already understand basic options trading strategies.
If you’re new to options and want to see if options trading is for you, sign up for Investors Alley’s “Options Floor Trader PRO” to start small with spare cash in your portfolio.
Capital Gains: Trimming Your Winners
If stocks or other assets in your portfolio rise in price, you can sell some of them to lock in capital gains. There are several reasons for that.
Second, if some of your stocks surge and outperform everything else, your portfolio will become unbalanced. You become exposed to the risk of a stock price correction, which increases the total risk of your portfolio. Instead, you can sell part of the position to take a profit and buy some other assets.
Ideally, you should only sell assets that you’ve held for a year or longer. In that case, your long-term capital gain would be subject to a lower tax rate.
Diversification of Portfolio Income
As we’ve seen, there are lots of different sources of portfolio income. You shouldn’t just pick one. Instead, keep a diversified portfolio.
Diversification is easy to understand intuitively: Don’t keep all your eggs in the same basket. If it falls, all the eggs will break.
Similarly, if you only rely on bonds, an interest rate hike would hit the market prices of your entire portfolio. If interest rates rise, new bonds would have higher yields. And investors won’t buy your older, lower-yielding bonds except for at lower prices.
The same applies to stocks: If you only hold stocks, in a recession, your whole portfolio could suffer.
Yet if you hold both bonds and stocks, one part would compensate for the other. That’s because central banks usually increase rates (bad for bond prices) when business activity is high (good for stocks). And they lower interest rates (good for bond prices) when the economy slows down.
So the key to a balanced portfolio is to hold different asset classes, even if some of them generate lower income.
Things to Consider When Adding Investments to Your Portfolio
Besides the potential income, you should consider each new investment from several perspectives, including:
- Risk of loss of capital: How likely is it that you’ll lose the whole position? For savings accounts, that’s nearly zero, while for high-yield bonds that’s a possibility.
- Liquidity: How easy is it to sell the investment and close the position? While selling stocks is easy, real estate is difficult to sell fast.
- Price volatility and correlation: How much could market prices move? Are these moves correlated with other assets in your portfolio?
- Income stability: Are cash flows guaranteed? Bonds and other fixed-income instruments are stable, while the size of dividends depends on the company’s performance.
- Tax treatment: The IRS treats different types of income differently, and the actual tax rate also depends on the taxpayer. It’s important to consult your tax adviser.
To sum up, the appropriateness of an investment depends on your risk tolerance and other assets in your portfolio.
Build Your Investment Portfolio
We’ve explained what portfolio income is, reviewed different sources of income, and looked at criteria that should be considered. Your total return includes not only cash flows but also capital gains from price appreciation of different assets.
There are many ways to get a return. But because the low-yield environment is likely here to stay for the foreseeable future, dividends are currently the main source of income for most portfolios. To find high-quality dividend stocks, sign up for Investors Alley’s “Dividend Hunter” newsletter.