Income investing is a wealth-building strategy that involves assembling a portfolio of assets that generate dependable cash payouts. For most investors, that means putting together a collection of dividend-paying stocks and high-quality bonds that can be counted on as a source of cash requiring little, if any, extra work or input from the investor.
A well-constructed portfolio of dividend stocks and bonds can be one of the most accessible and rewarding routes to building a substantial stream of "passive income." As Warren Buffett once said, "If you don't find a way to make money while you sleep, you will work until you die." These words from the Oracle of Omaha might sound a bit gloomy, but they highlight the important role that passive income streams play in building wealth and how being financially prepared can open the doors to living the kind of life you want.
Who is income investing for?
Some people think that income investing is only for older investors and retirees, and there are valid reasons for this association. However, the truth is that income-generating investments can be valuable financial vehicles for people of all ages. Stocks that pay dividends have tended to outperform those that do not, and high-quality bonds are one of the safest ways to preserve wealth and prevent the purchasing power of your savings from being eroded by inflation. So, there's no reason to think too narrowly when it comes to who should be employing income-investing strategies.
The ideal makeup of an income-generating portfolio will vary depending on what the investor is hoping to achieve and the degree of risk that he or she is comfortable with. Thus, it's helpful to have an understanding of the different types of assets that can make up an effective income-generating portfolio, some metrics and characteristics to use and look for when evaluating different candidates, and a clear idea of what your goals are in order to figure out the strategies and holdings that best suit your individual needs.
Components of an income portfolio
Among the investments you'll find in a typical income-generating portfolio are the following:
- Dividend stocks
- Real estate
- ETFs and mutual funds
We'll look at each of these in turn below, along with some other types of accounts that generate investment income.
Bonds are loans to a government entity or company, and they pay a fixed amount of income as interest on a predetermined schedule. When the loan term ends, the bond holder receives the loaned amount back. The rate of interest varies according to term, creditworthiness of the borrower, and market conditions.
There are two main types of bonds.
- Government bonds are generally seen as safer, as government entities have the right to collect taxes to raise money to repay their debt.
- Corporate bonds have a higher risk of default, as some companies go out of business without being able to pay back their debt, but they tend to have higher interest rates to compensate for that increased risk.
Read More: How to Invest in Bonds
Dividend stocks are stocks of companies that choose to make cash payments to shareholders on a regular basis. Dividends are essentially a way for companies to pass part of their earnings to investors, and companies typically pay them out of the free cash flow their businesses generate.
The best dividend stocks consistently pay dividends and raise the amount they pay over time. That gives investors the income they need as well as growth to keep up with rising costs over time.
Read More: Get Started Dividend Investing
Real estate and income investing
Many investors turn to real estate as a means of generating income. The right real estate investments can generate more income from rental payments than you have to pay in property-related expenses and financing costs. Any residual income is yours to keep.
Real estate also has additional advantages. It can diversify your investment portfolio beyond stocks, bonds, and more traditional income investments. Real estate also offers some tax benefits that other income investments don't. Combined with the possibility of property values rising, real estate can be an attractive choice for those seeking income.
ETFs and mutual funds
Rather than purchase individual investments, investors can also buy shares of exchange-traded funds (ETFs) or mutual funds. Both of these investment vehicles offer exposure to a wide array of investments while giving access to investors with modest amounts of money to invest. There are numerous ETFs and mutual funds that specialize in income investments, with some taking a broader approach to include different kinds of investments, while others concentrate on certain categories like bonds or dividend stocks.
Other types of income-generating investments
Stocks, bonds, and funds will make up the core of most income-focused portfolios, because they tend to have higher yields compared to other vehicles. But it's also worth touching on a few other ways that investors can put their cash to work:
- Certificates of deposit, or CDs, involve lending money to a bank for a fixed period of time in exchange for interest payments. The returns on a CD are typically much lower than other investment options but with far less risk.
- Savings accounts and money market accounts are also accounts that banks offer. Savings accounts pay relatively little interest, but they let you withdraw money at any time. Money market accounts are similar to savings accounts, but they pay higher interest in exchange for giving up some flexibility in access to your money.
Income investing and asset allocation
Any of the income-generating assets mentioned above can be good tools for income investors to use, but many find that the best way to build a portfolio is to have several types of assets. That way, if one type of asset performs poorly, the others might do better and help reduce the negative impact from the poorly performing income-generating asset. For instance, prices of dividend stocks and bonds sometimes move in opposite directions, meaning that gains in one areas can offset losses in another. That smooths out the returns for your portfolio.
Key terms for income investors to know
There are several terms that income investors should be familiar with in order to invest more effectively. Payout ratios can tell you if a dividend stock is likely to sustain its current payout, while payout growth measures how much an income investment has increased its income payments over time. Dividend yield is a key measure of the amount of income dividend stocks pay.
- Payout ratio -- the percentage of a company's earnings or free cash flow (FCF) that goes toward covering its dividend distribution. Payout ratios are calculated by dividing annual earnings or FCF by the total dollar amount of dividends that a company has distributed or will distribute in a given year.
A payout ratio above 100% indicates that a company is generating less cash than it is paying out in dividends. In this case, a company would have to tap into its cash assets or take out debt in order to fund the distribution. This dynamic typically isn't sustainable, and it often signals that a dividend cut or suspension is on the way. Companies with lower payout ratios of 50% or less have more leeway to raise their dividends, especially once they've gone through their fastest growth phases and don't need to reinvest as much of their profits back into growing their businesses.
- Payout growth -- the extent to which a company has increased its payout per share over a given period of time. A payout growth rate can be calculated by taking the dividend at the ending point of a given time period, subtracting the dividend value at the starting period of your comparison, and then dividing the resulting value from the dividend at the starting point of your comparison.
In general, the faster the payout growth rate, the better a dividend stock's business is doing. In addition, the long-term track record of payout growth is important in assessing how likely dividends are to rise in the future.
- Dividend yield -- the percentage that a company's annual dividend payout represents as a percentage of the company's stock price. Yield is calculated by dividing the company's annualized dividend by its stock price. So, if a stock pays out $1 in dividends per year and is priced at $50 per share, it would have a yield of 2%.
The sweet spot for dividend yields is generally somewhere between 2% and 6%. Below 2%, stocks don't generate enough income to satisfy most income investors. With yields above 6%, stocks often have risk factors that can make them more dangerous than dividend stocks with slightly lower yields.
What should income investors know about dividends?
There are several concepts that income investors should understand about the role dividend stocks can play in their portfolios. Among them are the following:
- Reinvesting dividends -- If you don't need income now, then reinvesting dividends puts the power of compounding to work for you. Using a dividend reinvestment plan, or Drip for short, takes the dividend payments and buys more shares of stock, which in turn can increase your dividend income in future.
- Dividend frequency -- Regular dividends are typically paid quarterly, although some pay monthly, annually, or on other schedules. Companies can also pay special dividends from time to time.
- Taxes on dividends -- In general, dividends are taxable income. However, preferential tax rates for many dividend stocks can lower or even eliminate the tax burden income investors face. Taxes also depend on what kind of account you have holding the stocks.
- Dividend-growth investing -- Dividend-growth investing involves selecting stocks with rapidly increasing payouts even if they offer relatively small yields -- with the understanding that they can build to having much bigger yields over time. Dividend-growth stocks can offer investors a good balance between a growing returned income component and a better chance at seeing the stock price go up than those that already offer big yields. To identify such stocks, it's useful to look at companies that consistently increase their dividend payouts each and every year. Some exceptional dividend stocks have streaks of annual dividend hikes extending 50 years or longer.
Good stocks and ETFs for an income-investing portfolio
With some important metrics and criteria for dividend stocks established, it's a good time to move on to a sample of worthwhile income-generating securities. Below, you'll find a list of high-quality, income-generating stocks and ETFs that are worth considering for your portfolio.
|Vanguard High Dividend ETF (NYSEMKT:VYM)||N/A||
|Vanguard Dividend Appreciation ETF (NYSEMKT:VIG)||N/A||
|PepsiCo (NASDAQ:PEP)||Food and beverage||
|The Walt Disney Company (NYSE:DIS)||Entertainment||
|Realty Income (NYSE:O)||Commercial real estate||
Vanguard High Dividend Yield ETF and Dividend Appreciation ETF
Vanguard has an excellent reputation in the financial services space, and the company has two dividend-oriented ETFs. The High Dividend Yield ETF tracks the FTSE High Dividend Yield index and bundles together more than 400 different stocks with above-average dividend yields from a wide variety of industries. The Dividend Appreciation ETF tracks the NASDAQ US Dividend Achievers Select index and combines more than 180 stocks with strong payout growth track records.
Both ETFs have low costs compared to competitors. That lets investors keep more of the income the ETFs generate.
PepsiCo has a consecutive annual payout growth streak that spans multiple decades. The beverage and snack foods stock has historically offered a yield that's significantly above the market average, making it a favorite among income-focused investors.
The company has faced some pressures from changing consumer trends. However, the company has worked to meet those shifting demands, and its massive global distribution network and supply chain advantages create a formidable moat. PepsiCo's business looks sturdy enough to keep cash flowing back to shareholders for decades to come.
The Walt Disney Company
Disney's dividend yield usually comes in below the market average, but the House of Mouse has delivered rapid payout growth and generates enough earnings and free cash flow to keep its payout ratios low. Its fantastic brand strength and highly integrated business model put it in position to thrive and continue rewarding shareholders despite changes in the media landscape.
Disney has leaned heavily on its media networks segment, and the impact of cord-cutting has led it to pivot toward streaming video. Elsewhere, the company's filmed entertainment, theme parks, and consumer products divisions continue to look strong. Dependable consumer demand for entertainment combined with the company's talent for creating new content should support rising payouts over time.
As its name suggests, Realty Income generates rental income from its real estate investments. As a REIT, the company has to return at least 90% of its earnings to shareholders in the form of cash dividends, and Realty Income has a long history of rising payouts.
Realty Income has concentrated on tenants with relatively strong businesses to ensure future income flows. Realty Income also pays its shareholders on a monthly basis -- a characteristic that could make the stock appealing for retirees looking to supplement their Social Security income.
Intelligent income investing is a path to financial success
There are many worthwhile income-generating securities that investors can explore and employ in their wealth-building pursuits, and there's no surefire, one-size-fits-all approach to income investing that will meet the needs of every investor and guarantee success. Investors should always research and evaluate the assets and strategies that best suit their needs.
Building a portfolio around income-generating stocks backed by high-quality businesses and cost-effective ETFs and adding some bonds for diversification is a time-tested way that many income investors use to achieve their long-term financial goals. That strategy can work for you as well.