How the Income Investing Strategy Works

When you work with an investment firm to create a portfolio, they will ask you to choose which strategy you want to use. You'll be able to select from a pre-existing checklist that might include strategies such as capital preservation, inflation-adjusted capital preservation, value, growth, high growth, speculation, and income. This is known as an investment mandate, and your portfolio managers will work to invest according to the mandate.

Income investing is a type of investing strategy that is designed to produce funds for you to live off of. There are many types of stocks, bonds, ETFs, or other investment instruments that can be used for this strategy. If you plan to invest to generate a side stream of income, it will help you learn how the strategy works and the methods you can use.

The Goal of Income Investing

The income investing strategy involves building a portfolio of assets such that the holdings produce the highest annual passive income possible. The main reason investors create income portfolios for their clients is to provide them with a constant stream of extra cash.

Picture a teacher who earns $40,000 per year and their spouse who earns $55,000 per year as a real estate agent. Their joint income before taxes is $95,000. Suppose a great aunt dies, and they come into $1 million. By going with an income strategy that produces, say, 4% yearly payouts, they can make $40,000 in income from their portfolio each year, which increases their total income to $135,000.

The $1 million would serve as a sort of family endowment, used much in the same way as a college fund might be. It is money that is never spent but devoted solely to producing funds to be spent for other reasons. This strategy is very common with retirees who need extra cash to fund their basic costs of living at a time when they are no longer working or working very little.

Given the rise in the gig economy, this strategy can be relevant for a younger and growing population engaging in jobs with volatile and unpredictable incomes. Income from the portfolio can be used to pay bills, buy groceries, pay for health care, support charitable causes, cover the cost of college for a family member, or any other reason the investor sees fit.

Types of Holdings in an Income Portfolio

How each income portfolio is composed will vary, meaning it could include a wide range of types of assets at varying amounts. Still, all investors need to make sure they have diversity throughout their assets.

Blue Chip Stocks

Most income strategy portfolios will contain safe blue chip stocks. These are from major companies with solid track records of paying out dividends. Walmart and Disney are examples of blue chip stocks. These portfolios are also on the conservative side, with balance sheets that reflect a history of maintaining or increasing dividends per share, even when times are tough.

Bonds

Bonds and other fixed-income securities might be used as well. This depends on the tax traits of the account. For instance, if you're working with a Roth IRA or other tax shelter, it makes no sense to hold tax-free bonds. This type of account is better suited to treat taxed assets in your favor.

Real Estate

Real estate, whether you own a piece of property or have a real estate investment trust (REIT), is also a common asset to use in an income investment portfolio. REITs will carry more risk than most other assets in the portfolio because they are subject to market changes. Although, some amount of risk is not a bad thing when other assets are there to balance it out. If an investor knows what they're doing, and buys real estate at the right time, a REIT can create a great deal of wealth.

MLPs

Master limited partnerships (MLPs) are a unique type of publicly traded limited partnership that can be bought on an exchange just like stocks. Businesses owned by MLPs do not pay federal or state income tax. Instead, the investors who hold these assets must pay the taxes owed on their portion of the income. Because of the tax savings, MLPs tend to pay out higher dividends, making them a smart choice for income investment portfolios.

Cash

Cash reserves and cash equivalents are seldom used to make money. Instead, this allocation serves as a liquidity buffer or reserve. Large scale versions consist of FDIC insured checking and savings accounts and U.S. Treasury bills. But they can be used in an income portfolio when the goal is to keep some safety of principal.

A conservative income strategy portfolio should have enough cash on hand to maintain at least a year's worth of payouts, in the event the other assets stop paying out distributions. Money market accounts, money market mutual funds, and other interest-earning accounts can be great places to park surplus funds.

Pros and Cons of Income Investing

The clear bonus of opting for this strategy is that you derive an extra source of income. The income may be modest. Still, for the most part, you can rely on it. Also, it requires little to no work. When added to other income streams, you can increase your monthly cash flow and make life that much easier.

The one downside is that you forfeit the perks of compound interest. That's because the income you earn ends up in your pocket rather than put to use earning more. Suppose you construct a portfolio with an initial value of $100,000 that produces 5% annual payouts. Over 10 years, you will make $50,000. If the payouts were to be reinvested instead of withdrawn, you would make $62,889 over that same amount of time.

As a final note, it's much harder for an income strategy investor to use their full range of tools. For instance, deferred tax leverage is when you leave your capital invested to keep gaining interest. It can save you from paying hefty taxes when you withdraw or transfer funds.