Income investing is fundamentally different from investing for capital appreciation.
There are several advantages to income investing. For one, your income stream is reliable, and not price-dependent. The best income-generating investments keep paying investors to own them regardless of what’s happening to their stock price.
Second, if you invest right, your income stream can actually grow … sometimes while your portfolio is growing too! If you’re selling assets whenever you need cash, your portfolio will shrink over time. But if you own investments with growing income streams and rising prices, your income and your portfolio value can both increase over time.
Lastly, income investments’ reliable returns make them less volatile than the market. A recent study found that U.S. stock funds with yields over 2% (meaning they hold mostly dividend stocks) had an average three-year annualized standard deviation (a measure of volatility) of three percentage points less than stock funds yielding less than 2%. In addition, many income investments actually become more popular when the market is weak, so they can be great buy-and-hold assets for investors who don’t want to have to trade a lot.
So You Think Income Investing is Right for You?
The first step to income investing is to consider your income needs or wants, and your risk tolerance. There are some income investments that return as much as 10% of your investment as income each year—but they’re generally going to be much higher risk than an investment that returns 2% or 3% each year.
That amount—the percentage of your investment that is returned as income each year—is called yield. If you’re looking at a dividend-paying stock and see that it has a 3% yield, that means that at the current dividend rate, an investor who puts $1,000 in that stock will get paid $30, or 3% of his investment, each year in dividends. Those dividends are on top of any price appreciation from the stock, and don’t reduce the amount of your original investment. The investment is just paying you to own it.
Here’s how you determine the yield of an investment:
Yield = Annual Dividend Amount / Price
When you’re considering buying a new investment, you will use the current indicated annual dividend amount (how much the company has declared it will pay in dividends that year) and the current price in that calculation. That will tell you what percentage of your investment you’ll receive as income each year, as long as the company maintains its current dividend rate. This number is widely available on many quote services.
The other part of the equation is risk. Obviously, you’d like to maximize your income, but simply buying all the highest-yielding investments you can find is a sure recipe for disaster. For one thing, there aren’t that many (about 100 stocks in the S&P 1500 currently yield over 4%.) And you don’t want to buy subpar stocks just for the yield—if the company is struggling, it won’t be able to maintain that yield for long.
So with income investing, you need to balance yield against the other factors that matter to you in your investments: things like volatility, diversification, capital appreciation potential and income growth potential. Luckily, there are a wide variety of different investments that pay you to own them, so every investor should be able to create a mix of holdings that fulfill both their income needs and other criteria.
Income Investing Options
There are a variety of income investment types, including dividend stocks, real estate investment trusts (REITs), master limited partnerships (MLPs), business development companies (BDCs) and bonds. Regardless of which income-generating vehicle you choose, income investing is a way to minimize your risk and protect your portfolio against huge losses. It’s a way to fortify yourself against market volatility and the wild share-price fluctuations it brings.
To help guide you in your income investing, we offer Cabot Dividend Investor, a service that has beaten the S&P 500 since its inception in February 2014, featuring stocks and bonds that boast an average yield of 2.9%.
To subscribe to Cabot Dividend Investor, click here.