Steps for beginners to successfully invest in income

Steps for beginners to successfully invest in income

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:

  1. 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.

  1. 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.

  1. 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.

  1. New Alternative Investment

 The investments that are traditionally called alternative investments include gold and hedge funds, and they can provide good, solid returns, but they've been inconsistent performers of late. The average hedge fund returned about 8.5% in 2017 which doesn't sound bad until you compare it with the S&P 500's return for the same time period.  Tracking the value of gold through the GLD ETF indicates that its 3-year and 5-year numbers are in negative territory, although the 2017 one-year return was positive at 12.81%.

Cryptocurrencies Are the New Alternative Investment.

The investment performance will also vary based on how you choose to invest in cryptocurrency. You can invest directly in a cryptocurrency such as Bitcoin or Ethereum, or over 1,400 others in existence (with new ones continually appearing), a company involved in developing blockchain technology, or firms that have specialized equipment that's involved in mining cryptocurrency.

Many investors are still skeptical and think that Bitcoin is nothing more than a Ponzi scheme. However, companies like Overstock.com, eBay, Amazon, Target, and Expedia are now accepting it as a form of currency similar to credit cards.

Consider Alternative Investments as Part of a Portfolio

The time has almost arrived for investors and financial firms to classify investing in Bitcoin, cryptocurrencies and blockchain-based technologies as alternative investments, and thus having a place in a properly allocated investment portfolio. Over the next few years, it's clear there will be more and more opportunities to invest in them. As these investment opportunities open up, they need to be classified appropriately in order to be placed in investor portfolios using proper asset allocation models.

Many people will dismiss them, potentially including your advisor. With the progress (and profits) being made, however, over the next year or two, you might start hearing a lot more about how they may fulfill the alternative investment portion of your portfolio.

The point here is not to convince readers to invest in Bitcoin, GBTC (Grayscale Bitcoin Investment Trust) or other cryptocurrencies, but to inform them that many others are doing it. 

A 2015 survey showed that advisors had 73% of their clients in alternative investments and that 70% of advisors planned to maintain their current alternative investment allocations for clients, although half of them felt that alternative investments had underperformed since 2008. Most advisors were recommending a range of 6% to 15% of a client's portfolio to be held in alternative investments. Many others (18% of advisors) were recommending 16% to 25% of their clients' portfolios in alternatives.

A closer look at each category can give you a better idea of appropriate investments for income investing portfolios.

 

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, Cryptocurrencies)? 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:

  • 1/4 of assets in dividend-paying stocks that meet previously stated criteria
  • 1/4 of assets in bonds and/or bond funds that meet previously stated criteria
  • 1/4 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.
  • Invest 1/4 in mainstream cryptocurrency (Bitcoin).

 

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: $87,500 invested in high-quality dividend stocks that have an average yield of 4.5%. Expected annual income: $3,938
  • Bonds: $87,500 invested in high-quality bonds that have an average yield of 4.5%. Expected annual income: $3,938
  • Real Estate: $87,500 used as 50% equity combined with another $87,500 borrowed from the bank to buy a total of $175,000 in property. After expenses, maintenance, costs, and vacancies, the expected annual income is $12,196.
  • cryptocurrency (Bitcoin): Invested $87,500 in high-quality cryptocurrency (Bitcoin) with an average yield of 20%. Expected annual income: $17,500
  • Grand Total Pre-Tax Income: $37,572 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.

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