The idea of collecting checks for the rest of your life and generating passive income can be very compelling. If this sounds like the type of investing strategy that appeals to you, you may want to learn more about dividends and dividend investing.
This guide to dividends was designed as part of the guide to investing in stock to help answer all of your questions and walk you through the basics step-by-step, from how to select investments to enrolling in dividend reinvestment programs.
What Is Income Investing?
The art of good income investing is putting together a collection of assets such as stocks, bonds, mutual funds, and real estate that will generate the highest possible annual income at the lowest possible risk. Most of this income is paid out to the investor so they can use it in their everyday lives to buy clothes, pay bills, take vacations, or whatever else they would like to do.
Finding a Monthly Income Target for Your Portfolio
To find the monthly income your investment strategy needs to bring in, you will mainly be concerned with your withdrawal rate, which is how much income you pull out from your investments each year.
The rule of thumb in income investing is if you never want to run out of money, you should take no more than 4% of your balance out each year for income. This is commonly referred to on Wall Street as the 4% rule.1 Put another way, if you manage to save $350,000 by retirement at age 65 (which would only take $146 per month from the time you were 25 years old and earning 7% per year), you should be able to make annual withdrawals of $14,000 without ever running out of money.
If you are an average, retired worker, you will receive close to $1,500 per month in social security benefits. A couple, both receiving social security benefits, will average around $2,500.2 Add a $1,166 per month withdrawal from a pension fund, and you have a comfortable $3,666 per month income.
By the time you retire, you probably own your own home and have very little debt, so absent any major medical emergencies, you should be able to meet your basic needs. If you're willing to risk running out of money sooner, you can adjust your withdrawal rate. If you doubled your withdrawal rate to 8% and your investments earned 6% with 3% inflation, you would actually lose 5% of the account value annually in real terms.
Key Investments for Your Income Investing Portfolio
When you build your income investing portfolio, you are going to have three major "buckets" of potential investments. These include:
- Dividend-Paying Stocks: Both common stocks and preferred stocks are useful. Companies that pay dividends pay a portion of annual profit to shareholders based on the number of shares they own.
- Bonds: You have many choices when it comes to bonds. You can own government bonds, agency bonds, municipal bonds, savings bonds, or others.
- Real Estate: You can own rental properties outright or invest through real estate investment trusts (REITs). Real estate has its own tax rules, and some people are more comfortable because real estate offers some protection against high inflation.
A closer look at each category can give you a better idea of appropriate investments for income investing portfolios.
Dividend Stocks in an Income Investing Portfolio
In your personal income investment portfolio, you'd want dividend stocks that have several characteristics.
- Dividend payout ratio: You'd want a dividend payout ratio of 50% or less, with the rest going back into the company's business for future growth.
- Dividend yield: If a business pays out too much of its profit, it can hurt the firm's competitive position. A dividend yield of between 2% and 6% is a healthy payout.
- Earnings: The company should have generated positive earnings with no losses for the past three years, at a minimum.
- Track record: A proven track record of (slowly) increasing dividends is also preferred. If management is shareholder-friendly, it will be more interested in returning excess cash to stockholders than expanding the empire.
- Ratios: Other considerations are a business's return on equity (ROE—after-tax profit compared to shareholder equity), and its debt-to-equity ratio. ROE and debt-to-equity should be healthy when compared to industry peers. This can provide a bigger cushion in a recession and help keep dividend checks flowing.
Bonds in an Income Investing Portfolio
Bonds are often considered the cornerstone of income investing because they generally fluctuate much less than stocks. With a bond, you are lending money to the company or government that issues it. With a stock, you own a slice of the business. The potential profit from bonds is much more limited; however, in the event of bankruptcy, you have a better chance of recouping your investment.
Your choices include bonds such as municipal bonds that offer tax advantages. A better choice may be bond funds, which are a basket of bonds, with money pooled from different investors—much like a mutual fund.
Here are some bond characteristics you will want to avoid:
- Lengthy bond duration: One of the biggest risks is something called bond duration. When putting together an income investing portfolio, you typically shouldn’t buy bonds that mature in more than 5-8 years because they can lose a lot of value if interest rates move sharply.
- Risky foreign bonds: You should also consider avoiding foreign bonds because they pose some real risks unless you understand the fluctuating currency market.
If you are trying to figure out the percentage your portfolio should have in bonds, you can follow the age-old rule—which, according to Burton Malkiel, famed author of A Random Walk Down Wall Street and respected Ivy League educator, is your age. If you're 30, then 30% of your portfolio should be in bonds. If you're 60, then 60% should be.
Real Estate in an Income Investing Portfolio
If you know what you’re doing, real estate can be a great investment for those who want to generate regular income (picture payments rolling in each month). That’s especially true if you are looking for passive income that would fit into your income investing portfolio.
Your main choice is whether or not to buy a property outright or invest through a REIT. Both actions have their own advantages and disadvantages, but they can each have a place in a well-built investment portfolio.
This method is not without risk and you shouldn't just put 100% of your investments into property. There are three issues with this approach:
- If the real estate market falls, the loss is amplified by leverage; the use of debt to finance your real-estate purchases.
- Real estate requires more work than stocks and bonds due to lawsuits, maintenance, taxes, insurance, and more.
- On an inflation-adjusted basis, the long-term growth in stock values has always beat real estate.
Allocating Your Investments for Income
What percentage of your income investing portfolio should be divided among these asset classes (stocks, bonds, real estate, etc.)? The answer comes down to your personal choices, preferences, risk tolerance, and whether or not you can tolerate a lot of volatility. Asset allocation is a personal preference.
The simplest income investing allocation would be:
- 1/3 of assets in dividend-paying stocks that meet previously stated criteria
- 1/3 of assets in bonds and/or bond funds that meet previously stated criteria
- 1/3 of assets in real estate, most likely in the form of direct property ownership through a limited liability company or other legal structure.
While simple, this example allocation may not be what's best for you individually. If you are young and willing to take risks, you may allocate more of your portfolio towards stocks and real estate. The higher risk you take can potentially lead to higher rewards. If you are risk-averse, you may want to allocate more of your portfolio to bonds. They are less risky and offer lower returns as a result. There is no one size fits all portfolio.
The Role of Saving in an Income Investing Portfolio
Remember that saving money and investing money are different, though they both serve your overall financial plan. Even if you have a broadly diversified income investing portfolio that generates lots of cash each month, it is vital that you have enough savings on hand in risk-free FDIC insured bank accounts in case of an emergency.
Funds saved in a bank account are liquid and can be quickly withdrawn if needed. When all your funds are invested, your capital is tied up and you could be forced to liquidate positions in order to clear some capital. Doing so could result in negatively affect your returns and tax efficiency.
The amount of cash you require is going to depend on the total fixed payments you have, your debt levels, your health, and your liquidity outlook (how fast you might need to turn assets into cash).
Understanding the value of cash in a savings account cannot be overstressed. You should wait to begin investing until you have built up enough savings to allow you be comfortable about emergencies, health insurance, and expenses. Only then should investing be conducted.