Look up & say thank you Jesus!

Let’s talk income investing, what it is and why it might make sense to include in our portfolio. If cash is king, then cashflow is queen? I’m not sure, but income investing is certainly about cash flow generation. In this post you’ll find a great many reasons why income investing may or may not be a useful investment approach.

Before I get ahead of myself, this post is not a recommendation to participate in any strategy. I’m just a stranger on the internet sharing some knowledge. Always check with a professional or fully consider the consequences before investing.

Post Contents

Cash Flow

If you’re seeking a consistent income stream then income investing is one viable solution. By investing in assets that return a higher than average yield the investor will regularly receive income from such an investment.

Historically, cashflow is returned on a quarterly basis but monthly payouts are becoming more common. With the return of higher interest rates, more investors are turning to treasuries or bonds to both protect their capital and keep up with inflation. These assets commonly make coupon payments or return interest on a monthly basis. Because of this, many new income investment opportunities are electing to participate monthly as well. Additionally, several new investment vehicles have introduced the option for weekly dividend payments to make cashflow management easier than ever before.

Cash flow is the process of cash flowing from one hand to another. In this case, cash flowing from the investment back to the investor. How that cash flow is returned though is important. Most would prefer the dividend be paid as a qualified dividend but the reality is most assets designed for income do not. Rather, the capital is returned to the investor in a few ways; return on capital, non-qualified dividend, or interest income. All of which are considered ordinary income. We’ll talk more about this later but in short, ordinary income is generally taxed at a higher percentage.

Diversification

This can be a trigger word for many investors. Some demand it and others despise it. The argument in favor states that through a well diversified portfolio an investor will weather market turmoil with differing assets offsetting one another. The later contends that diversification limits return and is only suitable for someone lacking proper understanding.

Nevertheless it’s an important consideration prior to beginning any investment strategy. Fail to diversify sufficiently and the result could be a substantial loss of capital. Alternatively, over diversify and it’s difficult to get ahead as portfolio laggards continue to draw down potential capital gains.

With income investing, diversification can be a critical component to a successful investment. In my Unqualified Portfolio, I’ve opted for my income account to include a growth driver and several different income assets with a lesser allocation. I am however, mildly overweight in the financial sector as I attempted to diversify positions. I would have much preferred a closed end fund to minimize that concern but Robinhood doesn’t currently allow trading of closed end funds. For those interested, I have enjoyed good success with the Eaton Vance offerings.

Compounded Returns

As is the case with virtually every investment, investors seek to compound their returns over time. This is especially important to income investors if the goal is portfolio growth. However, most income focused investors are retired or nearing retirement so growth is usually a secondary concern. For them, safety of their principal balance and the generation of cash are the main attraction.

For those seeking growth, compounding the dividend payment by investing into additional shares can mean an ongoing income increase. Or as some view it, a pay raise! At every interval, investors not needing the cashflow today can simply put it back to work to generate a higher payment at the next payment date. Couple that with capital appreciation and the prospect for a healthy long term portfolio is clear to see.

For those seeking income, compounded returns is of lesser importance. While not out right neglected, income investors have identified the amount of cash flow they’ll need and maintaining that amount is the goal. In an ideal scenario, an investor would aim to generate enough cash flow to cover expenses while still returning a portion to the investment for growth.

Ultimately, it depends on what phase of life you’re in. Income investing may make great sense for those in retirement or nearing retirement. For those not there yet, income investing would be a reflection of risk tolerance and strategy to determine viability. I’ve personally adopted income investing for the sole purpose of paying for summer vacations. In theory, and given the accounts construction, I would be able to spin off enough capital each year without ever sacrificing the principal balance.

Asset Classes

The list of classes related to income can be long and their are nuances to each. Rather than a 100 point list I’ll highlight a few of the primary classes for initial consideration.

Again, this isn’t an exhaustive list. Rather, I hope it provides a relative starting point for someone thinking of entering the income investing domain. I’ve also added some relevant links to each of these points to conduct further research. Otherwise, I’d turn to Google or any one of the many AI tools for queries related to income asset types.

Risk Management

Likely the most important component to any investment strategy. It’s important to never step too far over the risk tolerance line or you’re sure to lose sleep and begin sipping pepto-bismol instead of sweet tea. In my opinion, the bulk of this is handled prior to ever having invested a single dollar. It’s never advisable to invest capital that cannot endure market fluctuations. Said another way, don’t invest money that cannot be lost.

That sounds a lot gambling, I know. The reality is we never know when the next market surprise may occur. Imagine waking up the day everyone found out about covid-19 only to see your investments down 20-50%. If you wouldn’t be able to endure a similar scenario then it’s likely you’re assuming too much risk. For comparison, those that were able to whether the storm have enjoyed an epic bull market and the returns to match.

With regard to income investing, several different risk factors must also be considered depending on the type of asset selected. Interest rate risks, credit risks, concentration risks, and general market volatility are all necessary ruminations prior to income investing. As is the case with any investment strategy, an understanding of the potential risks aligns itself with the probability for success.

Strategies

Another broad concept for income investors to surmise would be which strategy makes the most sense for a presumably limited amount of capital. The number of strategies is as unique as the hairs on your head so there isn’t a one size fits all approach. Many income investors opt to alter common strategies in pursuit of their own established goals. Doing so can increase the complexity but also provide the expected reward.

Some common income investing strategies include;

I’ve personally opted for the multi-asset approach or as I see it a multi-bucket strategy. Where some money is in a savings account earning a smaller interest, some is in treasuries earning slightly more interest, and some is in the market via equities, REITS, or derivatives. A more complex approach but one that suits me and manages risk based on time horizon.

Laddering Investments

Typically reserved for fixed income assets laddering is an investment strategy whereby the investor staggers the maturity dates of an investment.

Consider a certificate of deposit (CD) investment;

An investor wanting to ladder such an investment would hypothetically invest $1,000 into a 1-month CD, $1,000 into a 3-month CD, and $1,000 into a 6-month CD. In this way, the investor would receive their balance and interest at the end of the identified periods. Should interest rates rise, they aren’t locked in to the lower rate and should they decrease they still have a higher rate on some of their invested capital.

Additionally, laddering may also be used elsewhere in the market. For instance, income investors routinely identify preferred assets based on payment dates. Through careful structuring of a portfolio an investor can reduce variability and provide an expected income stream at predetermined intervals. A valuable concept for those choosing an income investing approach.

Uncle Sam and the Tax Bill

I’ve heard it said that those who intend to remain wealthy must have an understanding of taxes. Whether that’s true or not is up to you but it is true that the government will take as much as much as it possibly can. Therefore, it must also be true that we demand to keep as much as we can.

Now, I’m not a tax professional and there really is no substitute for consulting with a tax authority. They have more knowledge and unique strategies at their disposal to minimize uncle Sam’s reach.

That said, dividends are generally viewed as a taxable event. There are unique circumstances when capital is returned that may not be taxed as income but by in large taxes are incurred at each dividend or interest payment. As such, it would be a great oversight to neglect the tax liability while structuring an income focused portfolio.

There are several tax advantaged accounts that an cashflow investor should consider with the most well-known being, Traditional and Roth IRA’s. I’ve personally elected to hold most of my higher paying assets inside a Roth IRA to avoid any undue tax burden. However, there are several other account types that may be of interest if they’re available to you. Here is an articles listing several different tax advantaged accounts.

Derivative Strategy Investments

As investors grow and change so do the products available to them. As of today, there is an emergence of income producing assets focused on the use of options to generate higher than usual levels of income. The concept isn’t new but the number of investable assets of this type seems to grow each day.

In short, options are a derivation of the underlying security. Offering an investor the opportunity to mitigate risk, speculate, or generate an income. Through strategic covered call campaigns or cash secured puts an options investor may generate an additional 10-20% of income from an investment. Of course, there is no free lunch and options have unique risks and characteristics but that hasn’t stopped the onslaught of these assets.

There are several types of derivative strategy investments available but the most common utilizes a covered call system to generate additional income. Meaning, these investments can achieve upwards of 40% or even more in yield per year. Making the risk of principal erosion an important focal point. In fact, most assets in the space have a declining share price and are not intended for most investors.

Still, they offer an income investor plenty to consider. Personally, I’ve elected to use them as the smallest portion of my income producing account with hope they will meaningfully boost the income without completely destroying the total return profile. The later is still in progress though so more time is needed for me to fully evaluate this class of income producing assets.

Downsides to Income Investing

As is the case with literally every investment. Income investing isn’t without a fair number of challenges. Many of which make this approach one several investors simply say, “no, not gonna happen in a million years”. For them that is the correct response. Their risk tolerance or goals may be harmed adopting such a technique.

Of the common detractors to income investing, here are a few;

  • Limited Growth Prospects
  • Interest Rate Risks
  • Concentration Risks
  • Credit Risks
  • Opportunity Costs
  • Capital Erosion

Most of these have been discussed previously but as a brief review, income investing can limit the growth potential of an investment. Assets paying out an above average income typically don’t see explosive capital appreciation. In fact, the lesser desired outcome is more often true. Many of these assets face share price erosion over time and thus a poor investment choice for a great many investors.

The risks discussed earlier are the same here. Concentration risks essentially highlights the tendency for an investors to place more capital than they otherwise would solely for the benefit of a higher yield. Credit risks are really an evolution of the 2008 financial crisis, in my opinion, when the world took notice that corporations shouldn’t be trusted. In essence, credit risks arise when the institution defaults on its obligations.

Also true for any other investment is the opportunity cost. For example, suppose an investor elected to deploy a treasury ladder at 5.35% interest over the next year. So long as the US government didn’t default they would enjoy the payout from that ladder over the time period. Alternatively, they may have invested in Microsoft(MSFT) and earned 15% over the same period. Obviously, Microsoft performed better in this scenario. However, the opposite could also be true and Microsoft could have declined instead. The opportunity cost arises as an investor selects one avenue over another.

Interest Rates & the Federal Reserve

The Federal Reserve(FED) is the US’s central bank, established to create a stable monetary policy and financial system. As the FED raises or lowers interest rates they have an impact on the economy. Effectively impacting people and businesses ability to borrow. When interests rates are low, the idea of borrowing for a house or for capital expenditures becomes more enticing and therefore a boost to the overall economy. On the other side, when rates are higher or more restrictive, less borrowing occurs and as a result, less expenditures. The role of the Federal Reserve is to attempt a balance between the spectrum of accommodative and restrictive policy.

For income investors, the Federal Reserve Rate is of unique importance. As they raise or lower this rate, our income can also raised or lowered. For example, consider a bond investor deciding to invest when interest rates were relatively low. As the rate rises, the value of this investors bonds will decline because newer bonds offer a higher yield with the new higher rate. This may result in a capital loss to an investment largely considered safer than other assets on the risk scale.

In all, it remains important for income focused investors to stay abreast of changes or the possibility of changes to the Federal Funds Rate. I don’t personally believe it should be the primary consideration but it can not and should not be ignored.

Inflation: The Masked Bandit

Inflation can best be compared to rust. It’s the slow but ever present corrosion of our asset or our purchasing power over time. For context, $1,000 dollars in the year 2000 is the same as $548 dollars in 2024. In the past 24 years our purchasing power has declined by roughly 50%. For those opting to put there money under a mattress, they now have far less money than they once did.

Inflation is generally viewed by most Americans negatively. The idea that our money buys less over time isn’t a great quality, I’ll admit. However, had the investor that put that money under his mattress earned only 2-3% his money would still be as valuable today. Had this investor invested it in the S&P 500 his $1,000 would now be worth $2,533. Effectively beating inflation and earning a nice return.

Final Thoughts

In the end, whether income investing is the correct approach for you boils down to your risk tolerance, goals or objectives, and management ability. For me, income investing is a staple of my investment approach. All be it, to a much smaller extent. Still, the approach is one many investors enjoy each day as they’ve structured their holdings to provide for their lifestyles.

Income investing, like all forms of investing, has risks associated. Not understanding those risks or neglecting them all together is sure to bring financial loss. However, with careful consideration and a strategy for implementation it is possible to generate a stable, recurring cashflow portfolio.

By maintaining adequate diversification, conducting regular portfolio reviews, and staying abreast of economic changes investors can harness the power of income investing to achieve their financial goals.

Until next time.

God bless,

Jeff

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