Income Investing: The Smart Way To Reach Financial Independence - Physician on FIRE (2024)

You’ve worked hard for your money, and now you’re ready to flip the script. How would you like your money to work for you instead?

Income investing is the art and science of selecting assets that generate a reliable income. It isn’t just a financial strategy; it’s a lifestyle choice. It’s about building a portfolio that can support you and set you up for a comfortable retirement.

Let’s take a look.

What is Income Investing?

Income investing involves selecting assets that generate a reliable income. Common examples include dividends from stocks, interest from bonds, or rent from real estate.

The goal is to create a portfolio that pays you regularly, focusing on long-term sustainability rather than quick gains. Imagine a farm that yields crops all year round; that’s income investing for you.

Income Investing vs Growth Investing

As mentioned, income investing is like having a reliable farm that consistently produces food. Now, let’s contrast this with growth investing, income investing’s more glamorous cousin.

Growth investing is like hunting for treasure. You invest in assets you believe will increase in value over time. But the danger is that it’s riskier and more volatile.

Both approaches have their merits. Here’s an article that breaks down the risks and rewards of each: Income Vs. Growth Investing.

When considering income investing versus growth investing, it’s essential to think about your timeframe.

Growth investing tends to be better suited for longer time horizons, while income investing can provide more immediate cash flow.

If you’re looking to fund near-term expenses or supplement your current income, income investing may be preferable. However, if you have a longer runway until retirement or other financial goals, growth investing may offer greater total returns over time.

It’s also worth thinking about your temperament as an investor. Income investing provides more consistent cash flow, which can help weather volatility. Growth investing aims for higher returns but requires stomaching more ups and downs. Know yourself and what helps you sleep better at night. Mixing both strategies can provide balance, but your allocation should align with your risk tolerance and objectives.

Income Investing vs Growth Investing Comparison Table

Income Investing Assets

Now that you understand what income investing is, let’s explore the vehicles that can get you there. From dividend stocks to bonds to real estate and more, there are many options to consider, each with its own unique features.

Dividend Stocks

Dividend stocks are the bread and butter of income investing. Companies that pay dividends are often well-established with a track record of generating profits. Dividends are a portion of the profits the company distributes to shareholders.

Historically, cash dividends have been seen as the primary method to reward shareholders for owning a company’s stock. Other methodologies include share buybacks and stock dividends. However, cash dividends remain the most common method for companies to periodically and consistently return value to shareholders.

Dividend stocks can be a great way to generate regular income, but it’s crucial to research the company’s financial health and dividend history. Dividends aren’t guaranteed; they’re usually tied to the company’s performance.

When evaluating dividend stocks, some key metrics to analyze include the dividend yield, dividend growth rate, and payout ratio.

• The dividend yield shows how much income you’ll earn relative to the share price. Look for stocks with higher yields, but make sure they’re sustainable.
• The dividend growth rate reveals how rapidly dividends are increasing over time. Faster growth means rising income.
• Finally, the payout ratio compares dividends paid to overall earnings. Lower ratios around 50% or less indicate dividends aren’t exceeding profits.

Diversifying across sectors and companies is also a good idea when investing in dividend stocks. This mitigates the impact if one company cuts its dividend. Building a portfolio of stocks with long histories of dividend growth can provide inflation-beating income that continues rising over time.

Mutual Funds and ETFs

The most common way to invest in dividend stocks is to buy mutual funds or exchange-traded funds (ETFs).

These funds were designed to allow investors to pool money together and buy a large portfolio of stocks. When you buy a share, you become a part owner of all the investments in the fund, and the income they generate.

ETFs and mutual funds are mostly distinguished by their trading mechanisms. ETFs trade on stock exchanges throughout the trading day, while mutual funds are priced and traded based on their end-of-day net asset values (NAV).

That means, mutual funds are purchased at the price of the next market closing time. On the other hand, ETFs fluctuate throughout the day, and you’ll pay a small premium to the current asking price (the bid / ask spread) when you purchase them.

Mutual funds can also easily be exchanged for another fund without you missing a day or two in the market, which is a benefit when tax loss harvesting. You don’t have to bother with a settlement fund when buying and selling mutual funds.

One advantage of ETFs is that they can offer lower expense ratios and they can be slightly more tax-efficient.

That said, you don’t have to choose between mutual funds and ETFs. Many investors will have both, and it’s not worth losing any sleep over deciding which is best. Both accomplish the same thing — giving you ownership of a basket of stocks and/or bonds.

As you contribute regularly to these funds, your investments generate earnings, and those earnings, in turn, generate additional earnings. This compounding effect snowballs over time, leading to exponential growth of your initial investment.

Bonds

Bonds are the classic go-to for income investors. When you buy a bond, you’re essentially lending money to the issuer, be it the government or a corporation, in exchange for a fixed rate of interest.

While a bond is held, it will typically make interest payments to the lender. If there is no coupon payment, then the bond will be purchased at a discount to par value so that as time goes by, the bond appreciates as it gets closer to its maturity date. This bond’s appreciation replaces the interest earned by the periodic coupon payment. This is what is known as a zero-coupon bond.

If a bond is held until maturity, then the rate of return the investor can expect is called the yield to maturity. Maturity is the moment in time when the borrower must return the lender’s original capital as laid out in the bond’s contract.

The rate of return an investor expects to receive if held to maturity is called the yield to maturity. The yield to maturity is the rate the investor will receive barring some other negative event like the company going bankrupt or the bond getting called.

It is important to understand that a bond’s price will move while you own the bond. A bond’s movement in price is usually due to a change in underlying interest rates, but it may also change due to the public’s trust in the company’s ability to pay back the debt.

Assuming the bond’s price moves due to interest rates, a bond’s price will move inversely to interest rates. For example, if interest rates rise, then the price of the bond will decrease. Conversely, if interest rates decrease, then the price of the bond will increase.

When investing in bonds, it’s important to keep in mind that bond prices can be quite volatile. But. If holding the bond to maturity is your strategy, then volatility shouldn’t play a factor in your decision-making process. That’s because if your intention is to hold the bond to maturity, then the final price at maturity will be par value, regardless of the volatility before.

If volatility does play a role, then it is important to understand that longer-duration (synonym for time until maturity) bonds are more price-sensitive to interest rates. A one percentage point move in interest rates in either direction can make a bond with a duration over 10 years move quite significantly whereas it may only cause a short-term bond’s price with 3 years until maturity to barely move.

When building a bond allocation, consider mixing government and corporate bonds with varying maturities. Government bonds are safer, while corporate bonds offer higher yields but more risk. Shorter-term bonds see less price fluctuation when interest rates rise.

High-yield bonds offer greater income but require research to gauge the risk of default. Maintaining an appropriate weighting between stocks and bonds is vital for income investors. While bonds are often considered a safer bet, they come with their own set of challenges.

Bonds can be an excellent choice for those looking for lower-risk investments, but it’s important to diversify among different types of bonds and other asset classes. Always do your due diligence.

Related Reads:

Bonds: What Are They Good For? Part I

What Are They Good For? Part II

How, When, and Why to Buy I Bonds in 2023

Money Market Accounts

A money market fund is a type of mutual fund that invests in low-risk, short-term securities such as treasury bills, CDs, commercial papers, and repurchase agreements. These funds pay dividends based on the interest earned from the underlying securities listed above.

Money market funds typically seek to maintain a stable net asset value (NAV) of $1 per share. This means that the fund’s investment manager at a brokerage tries to keep the value of the fund’s assets and liabilities equal to $1 per share. The idea is this will track a dollar and provide interest or yield.

Money market funds are often used by investors as a place to hold cash while they are waiting to invest in other securities or to meet short-term financial obligations. The primary reason that most investors may choose a money market fund over savings accounts is the greater returns available within money market funds.

Compared to savings accounts, they pay significantly higher interest.

The dividend rate on these money market funds is known as the 7-day yield, and it represents the annualized dividends paid in the past seven days. At the time of this writing, several money market funds are paying ~5% 7-day yields, which is a considerably more attractive rate of return than the average savings account rate.

The main drawback is that money market account yields typically don’t outpace inflation. So, the purchasing power of your money may still decline over time.

Money market funds also lack FDIC or NCUA insurance. That means they don’t have the same level of protection as savings accounts within banks or credit unions.

Overall, money market funds function well as places to park cash for short-term goals or as part of an emergency fund due to their liquidity. However, income investors need other assets for long-term returns.

Related Read: Money Market Fund vs Savings Accounts: Which One Should You Choose?

Real Estate

There are many ways you can invest in real estate to generate income.

One way is to own it inside a retirement account — typically in a self-directed IRA — and is more commonly owned outside of an investment account.

You can also own the real estate property outright, which can offer both income and appreciation. This real estate investment strategy can include:

• Single-family rental homes
• Multi-family rental homes (duplex, triplex, quadplex, etc…)
• Larger apartment buildings
• Commercial Real Estate
• Farmland
• Mobile home parks
• Property to be developed (like our lakefront property)

Another entry point in this asset class is through Real Estate Investment Trusts (REITs). REITs are companies that own or finance income-producing real estate across various sectors. They provide a liquid, low-cost avenue for real estate investing.

REITs trade like stocks but must distribute most taxable income as dividends. When selecting REITs, research factors like property focus, geographic diversification, debt levels, occupancy rates, and dividend histories. Investopedia offers a comprehensive guide on how to invest in them.

Alternatively, crowdfunded real estate platforms allow you to pool money with others to invest in properties. You earn rental income and potential appreciation minus fees. With various options for differing levels of involvement, there are numerous ways to include real estate as part of a savvy income investing portfolio.

Breakdown of Income-Generating Assets

Building Your Income Investing Portfolio

Constructing a portfolio is like building a custom home. You need a blueprint, quality materials, and a clear vision of what you want the end result to be.

Let’s take a look at how to build a portfolio that aligns with your financial goals and risk tolerance, ensuring it’s tailored to your unique needs.

Goals

Before you create a portfolio, be clear on your objectives. What do you want your portfolio to accomplish?

To effectively set and achieve goals, utilize the SMART goal framework:

• Specific: Clearly define your goals. Avoid vague aspirations and pinpoint the exact outcome you desire.
• Measurable: Attach quantifiable metrics to your goals. This facilitates tracking and evaluation of progress.
• Achievable: Set goals that are realistic and attainable within your financial capacity and timeline.
• Relevant: Ensure that your goals align with your FIRE objectives and contribute to your overall financial strategy.
• Time-Bound: Assign a realistic timeframe to each goal. This creates a sense of urgency and motivates consistent action.

Assessing Your Risk Tolerance

Knowing your risk tolerance is crucial. It’s the compass that guides your investment decisions. Are you someone who can stomach market volatility, or do you prefer a more conservative approach?

When evaluating your risk tolerance, think about your investment timeline and income needs. If you’re investing for a far-off goal, you likely have greater leeway for riskier assets with higher return potential. More immediate income needs may call for lower-risk holdings. Striking the right risk balance is key.

Related Read: You Need an Investor Policy Statement

Asset Allocation

After assessing your risk tolerance, your next step is to assess your asset allocation.

Here’s PoF’s portfolio asset allocation in 2020:

• 50% US Stocks (with a tilt to small and value)
• 20% International Stocks (50 / 50 developed and emerging markets)
• 20% Alternatives (real estate and small business)
• 10% Bond & Cash (mostly bond plus cash emergency fund)

Is this the perfect asset allocation? No. There are many variations on how to find the right mix of asset classes based on your risk tolerance and financial goals.

Also remember, asset allocation is a dynamic process that requires periodic reviews to ensure it aligns with your changing needs and market conditions. For example, a younger investor might have a higher percentage of stocks, while someone closer to retirement might lean more toward bonds.

As a rule of thumb, subtract your age from 110 to determine your stock allocation, with the remainder in bonds and cash. For example, a 40-year-old would aim for around 70% stocks.

You can tweak this based on risk tolerance. Revisit your asset allocation at least once a year or when life changes like retirement occur – rebalance periodically back to your target mix.

Asset Allocation by Age

Philosophy

Do you want a diversified portfolio that yields less return but offers more stability? Or is your are willing to take higher risks in exchange for higher returns?

Also, consider your anticipated withdrawal rate, your philosophy in expense fees and how much time are you willing to spend re-balancing your portfolio.

Overcoming the Challenges of Income Investing

Every investment strategy has its hurdles. Income investing is no different. Whether it’s inflation, market volatility, or tax implications, challenges are par for the course. Here’s how to navigate these, ensuring you’re prepared for the bumps along the road.

Inflation Risk

Inflation is like that slow leak in a tire—you might not notice it right away, but over time, it can leave you stranded. To combat inflation, include equities, commodities, REITs, inflation-linked bonds, and similar assets.

Equities have historically delivered long-term returns exceeding inflation. Commodities like oil, metals, and agricultural products can also appreciate rising prices. Meanwhile, Treasury Inflation-Protected Securities (TIPS) and Series I savings bonds provide guaranteed protection against inflation. It’s essential to have assets that can potentially outpace inflation, ensuring your purchasing power remains intact.

Market Volatility

Market volatility is the bane of every investor. One day you’re up; the next, you’re down. The key to surviving market volatility is to diversify your investments. Diversification and proper asset allocation can act as your financial shock absorbers, helping you weather the ups and downs of the market.

Volatility is part of investing, but the worst thing you can do is panic. Having stop-losses in place can limit downside risk. Consider rebalancing during swings to buy low and sell high. And focus on the long term, avoiding emotional reactions. Keep in mind that time in the market matters more than timing it. Ride out short-term volatility for the long-run payoff.

Tax Implications

Taxes are a fact of life, and they don’t disappear when you start investing. In fact, they can take a significant bite out of your returns if you’re not careful.

Tax-efficient investing involves using tax-advantaged accounts and understanding the tax implications of your investment choices. It’s not just about what you earn but what you keep after taxes that counts.

Use IRAs, 401(k)s, HSAs, and other tax-advantaged accounts to grow your money tax-free or tax-deferred. Municipal bonds also avoid federal tax, while tax-managed funds aim to minimize distributions. Being mindful about taxes from the start helps you keep more of what you earn.

Conclusion

Income investing is a marathon, not a sprint. It requires careful planning, diversification, and a deep understanding of your financial goals and risk tolerance.

How will you supplement your fixed income along the way? Are you going all-in on dividend stocks, or does the stability of bonds appeal to you? Maybe a mix of both?

Get out your drawing board – craft your strategy using the concepts we’ve covered. Walk the path with patience and stay focused on the long term. Remember, the best portfolio is one that you can stick with through the market’s ups and downs.