Is an “income investing” strategy right for your portfolio?
The right answer requires a bit of nuance. While many investors may eventually want to rely on their portfolio for income, doing so does not necessarily require shifting toward income-generating investments.
This Insight explains why. Below, we define income investing, examine some common income-generating investments, and explain why this approach is likely not the best way to maximize total returns.
What is income investing?
Income investing refers to selecting investments based on their ability to generate income over a specified period. Specifically, the key distinguishing feature of this approach is a focus on investments that generate a consistent stream of payments. Compared to other investments, these payments mean that no sales are required to realize some returns as income.
Common examples include stock dividends, interest payments from bonds or interest-bearing accounts, and income from real estate or other assets. We explore the pros and cons of common investment income sources below.
There is a common misconception that portfolio construction should shift focus to income generation as investors enter withdrawal mode and require a regular, consistent stream of income. However, an overemphasis on income generation can adversely impact your long-term returns. In general, investors should focus on total returns and diversification in their investments.
What are the main sources of income investing?
In principle, any investment which generates a regular payment is an income investment. The categories below represent some of the most common investments chosen for their perception as stable income generators.
Dividends from Stocks
When you own stock (or shares in an equity mutual fund or ETF composed of stock), you have ownership in the company that issued the stock. Companies pay dividends to their shareholders to return a portion of their profits to investors.
In general, substantial dividends are more likely to be paid by mature companies, because they have less opportunity for expansion than growth-oriented companies. Dividend distributions to shareholders mean fewer dollars available to re-invest in the firm and generate greater returns.
Pros and Cons of Dividend Income
Dividend payments provide a supplemental source of income, which can be particularly comforting during market downturns. Stocks with relatively high dividend payments may benefit from a lower correlation with broader stock market performance.
However, dividend payments mean that you will lose control over when to pay tax on this investment income. When selling assets, by comparison, you can control the sale to generate both the desired amount of cash and the resulting tax due. Dividend payments may also fluctuate in frequency and value.
Historically, it is important to note that the majority of stocks’ returns are driven by price appreciation, not dividends.
In the simplest terms, bonds are loans made to the bond-issuing entity. Investors provide cash to the company, municipality, or other issuing entity, to finance their objectives. In exchange, the entity pays interest until the loan is returned. The interest payments provide an income stream to the investor.
The fixed interest or coupon payment from a bond provides a predictable income stream. Like any other loan, however, there is always some risk that the debtor will not repay the amount owed. While bonds typically exhibit less risk than stocks, they are not risk-free investments.
Pros and Cons of Bond Income
The fixed income stream of bond investments can help reduce the overall volatility of your portfolio. This income may be re-invested to help rebalance your portfolio or allocated to more valuable bonds as interest rates shift. Historically, bonds also benefit from low correlation with the stock market.
However, bonds typically provide a lower rate of return than equity investments. Finally, decreasing interest rates can also cause coupon payments to be re-invested in less valuable bonds as market conditions fluctuate (bond values move inversely to interest rate changes).
Real Estate Income
Real estate income refers to the payments generated by buying a property and leasing it. Compared to investing in stocks or other financial instruments, owning and managing property comes with regular expenses, and profits are likely to vary from period to period.
Pros and Cons of Real Estate Income
Real estate enjoys a relatively low correlation with the stock market, which can make real estate investments an attractive way to diversify. If classified as a rental property, a real estate investment can also benefit from tax advantages such as expense deductions and depreciation.
However, real estate investments do require a large upfront investment, and this loss of purchasing power comes with an opportunity cost. Historically, property values have increased at the broader rate of inflation, but there is no guarantee that property appreciation will keep up with the combined costs of inflation, operations costs, and upkeep demands. Costs for real estate properties can include management, maintenance, brokerage fees, and more. Generally, cash flows from real estate investments are uncertain, and these investments are relatively illiquid should you need more cash.
Income from a Covered Call Option Strategy
Individual stock owners may sell a call option on their stock and in doing so, receive a cash premium. Selling an option gives the right for the option purchaser to buy their stock at a specific price over a specific time frame. The option seller may feel confident the stock value will decline, or they may expect little volatility in the stock’s price. In these instances, the stock owner is selling options to receive income upfront.
Pros and Cons of Covered Call Options
Because you own the stock underlying the call option, it is said to be “covered”. Your risk is limited on the upside because you have the stock to deliver if it is called. However, selling a covered call option means that you will miss out on the upside potential if the stock appreciates, and the option is exercised. Selling covered call options is effectively an active, speculative investment strategy. These options are most useful when an investor seeks to enhance their yield on a stock and is comfortable with capping the stock’s upside.
Should you focus on income investing?
Contrary to the name, and to popular belief, you should not use an “income investing” approach merely because you are relying on your portfolio for income. If you focus on income exclusively, you will miss the opportunity to maximize total return. Instead, determine your cash needs and work with your financial advisor to raise the cash from your portfolio while optimizing your total return.