Investing Basics: Income investing 101
Do you need your portfolio to generate cash? Is paying your bills and having enough income to live on more important than growing richer? If so, you need to focus on income investing.
Income investing has been somewhat out of fashion with DIY investors, due in no small part to the fact that during the twenty year bull market, some have found it almost impossible not to pick winners; however, the wealth management industry has seen it all before and there, at least, income investing is alive and kicking.
Here we take a closer look at income investing, which assets might be appropriate for someone seeking income and the most common dangers they might face.
A brief history of income investing
Income investing is the accumulation of a collection of assets such as shares, bonds, mutual funds, and property that generates the highest possible annual income at the lowest possible risk.
Unlike strategies for long term wealth accumulation and capital growth, most of this income is paid out to the investor to fund their everyday living costs.
In the past income investing may have been the only option for those not afforded company perks or denied access to benefits; if state support is not available to you, the only alternative to abject poverty in retirement in the 18th and 19th century may have been financial self reliance.
‘most of this income is paid out to the investor to fund their everyday living costs’
Those excluded from the upper echelons of society found that income generated from investments in shares or bonds, was blind to whatever prejudices they faced; ‘trading’ was the sole preserve of the wealthy, but saving, and then income investing became one of the few answers to others less fortunate
Even as recently as the 1980s, a ‘widow’s portfolio’ designed to deliver income to the supposedly helpless little lady left behind was relatively commonplace; wealth managers would routinely take the life insurance money a widow received and put together a collection of assets to generate enough income for normal life to continue in the absence of a breadwinner.
Whilst it may be less prominent for wealth managers, those taking personal control of their finances today have fuelled a surge of interest in income investing and the pursuit of passive income.
The 4% Rule
A rule of thumb for income investors is that to avoid running out of money you should not take more than 4% of your account balance out each year; the ‘4% rule’ is based on academic research that shows that if the market crashes, 5% can cause you to run out of money in as little as 20 years, whereas 3% virtually never did.
Thus, if ‘Average Joe’ retires at age 65 with a pension pot worth £350,000 (approximately £150 per month from age 25 and growing at 7% p.a.), he should be able to make annual withdrawals of £14,000 (£1,666 a month pre-tax) without ever running out of money.
With the current state pension set at £8545 p.a., Joe can expect a combined income in the region of £22,545 p.a. and all else being equal, a well structured income portfolio shouldn’t ever run out of money.
Types of investments for an income portfolio
Income investors will typically create three major ‘buckets’ of assets:
Dividend paying shares: either common stock or preference shares in companies that reliably return profits to shareholders; choose companies with safe dividend payout ratios, meaning they only distribute 40% to 50% of annual profit, reinvesting the rest back into the business to keep it growing; a dividend yield of 4% to 6% is generally considered good.
What to look for in dividend stocks:
- A company that returns more than 50% of its profit can damage its competitive position; academic research suggest that much of the 2007/9 credit crisis could have been avoided if banks had lowered their dividend payout rates.
- Companies that have generated positive earnings with no losses every year for the past three years, at a minimum and aim for a dividend yield of between 2% and 6% – thus, a company valued at £30 a share paying 60p and £1.80 per share.
- A proven track record of increasing dividends – shareholder-friendly management will be more interested in returning excess cash to stockholders than expanding, particularly in mature businesses with little growth potential.
- A high return on equity (ROE) and little or no corporate debt; a company that can earn high returns on equity with little or no debt, is a better-than-average business, and more likely to keep paying in a recession.
- Income investing is about protecting your money, not punting on risky stock.
Bonds: Mr Bond would have it that ORB is the ‘only’ place for income but many types of bonds exist; corporate bonds, government bonds and savings bonds all deliver ‘fixed income’ – an agreed return on the money you lend them for the duration of the loan. Bonds of long duration may expose you to unacceptable market fluctuations – ‘duration risk’ – due to changing interest rates.
What to look for, or avoid in bonds:
Bonds are often the cornerstone of an income portfolio as they generally fluctuate much less than stocks. The potential profit from bonds is much more limited than equities but in the event of bankruptcy, you have a better chance of recouping your investment; bonds can be considered the Tommy Atkins of an income portfolio.
However bonds are not without risk and can deliver a unique set of risks for the unwary income investor:
- The LSE’s Order Book for Retail Bonds (ORB) has been extremely popular with DIY investors, but has failed to keep up with demand in terms of new issuance. It is a well trodden path, but some have been tempted, and devastated, by the siren call of unregulated ‘mini bonds’ offering eye-catching rates of return. To be avoided at all costs – much more at Retail Bond Expert.
- A better choice may be bond funds, which you can learn all about at Bonds vs Bond Funds.
- When looking at individual bonds, one of the biggest risks is something called ‘duration risk’; when putting together an income investing portfolio, you typically shouldn’t buy bonds that mature in more than 5-8 years because changes they can lose a lot of value if interest rates move sharply.
- Generally it is good practice to avoid foreign bonds because they can pose real risks unless you understand currencies.
- Another rule of thumb, this time for deciding upon the percentage of your portfolio to invest in bonds, is the ‘age-old rule’. If you’re 30, 30% of your portfolio should be in bonds; if you’re 60, it should be 60%.
Property: Those not wishing to own property assets directly can do so via a Real Estate Investment Trust – REIT – basically a company that invests in property. As a tangible asset, some investors enjoy the fact that property is something they can see and that gives them the peace of mind to stick with their financial plan in turbulent times.
Property can be a great investment for those who want to generate regular, ‘passive’ rental income from their income portfolio.
Do you want to buy a property outright or invest through a REIT? Each option comes with advantages and disadvantages, but can find a place in a well-built investment portfolio.
The advantage of property investing:
If you are comfortable using debt, you can drastically increase your withdrawal rate prom your portfolio because whereas inflation erodes the ‘real’ returns on your other assets, the property itself will generally keep pace with inflation.
Those with cash reserves or access to a facility to tide them over if a property is vacant for a period, or loses value, might be able to effectively double the amount of monthly income they could generate.
‘Fill your boots with cheap mortgage money and Google Zoopla?’
So, if property offers higher returns for income investing, why not invest 100% in property? Fill your boots with cheap mortgage money and Google Zoopla?
Aside from the all-your-eggs- in-one-basket folly, if the property market tanks, the loss is amplified by leverage.
Property requires more work than stocks and bonds with any number of complications, diversions and expenses including the seemingly transient nature of its tax treatment; on an inflation-adjusted basis, the long-term growth in stock values has always beaten property.
The role of saving in an income investing portfolio
Saving money and investing money are very different; even if you have a broadly diversified income investing portfolio that generates lots of cash each month, it is vital that you have enough available savings in case of an emergency. The precise amount you need will depend on your total fixed outgoings, debt levels, and perhaps influences such as your health – your ability to work – and your credit score – your ability to borrow.
Asset allocation in an income investing portfolio
What percentage of your income investing portfolio should be divided among these asset classes – shares, bonds, property, etc ?
This is where it gets personal; asset allocation is down to your personal choices, preferences, risk tolerance, and whether or not you can tolerate a lot of volatility.
The simplest income investing allocation would be:
1/3 of assets in dividend-paying stocks.
1/3 of assets in bonds and/or bond funds.
1/3 of assets in property
The numbers in detail:
What would this allocation look like in Joe’s real portfolio?
Stocks: £108,335 invested in high-quality dividend stocks with an average yield of 4.5%; expected annual income: £4,875
Bonds: £108,335 invested in high-quality bonds that have an average yield of 4.5%; expected annual income: £4,875
Property: £108,335 used as 50% equity combined with another £108,335 borrowed from the bank to buy a total of £216,670 in property; expected annual income after expenses, maintenance, costs, vacancies, etc: £15,100.
Grand Total Pre-Tax Income: £24,850 in cash; adhering to the 4% Rule, Joe takes just £14,000 a year, leaving £10,850 in his income investing portfolio. This setup should last you forever.
If that all sounds ludicrously simplistic; it is designed only to paint a range of broad principles and potentials; however, the reason there is an ‘Average Joe’ is because that is what he is.
‘the reason there is an ‘Average Joe’ is because that is what he is’
Property investing may not be for everyone – particularly not via direct ownership – but it does at least highlight the possibilities that exist outside of directly traded investments.
However, none of these decisions are to be taken lightly because any error or missed opportunity could have a direct bearing of the quality of the income investor’s quality of life at a time when they may be at their most vulnerable; however confident they may feel, or how experienced in the accumulation phase, that may be the point at which even the most ardent DIY investors seeks third party corroboration, if not going the whole hog with some one-off or occasional advice, but as we say, who cares more about your money than you do?
Learn much more: