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THE INSIDER’S GUIDE TO

INCOME INVESTING

By
The Financial Lexicon

In this document, I explore the idea of income investing, explaining

what it is and outlining why various assets classes and asset class
categories might be included in an income-focused investor’s
portfolio. I will also discuss the types of things income-focused
investors should concern themselves with from a macro-picture view. 

 Introduction to Income Investing

Over the course of an investing lifetime, many people will likely

experience changing investment goals, risk tolerances, and time
horizons. During the investing journey, especially in its latter stages,
many investors shift their focus to income generation rather than
capital appreciation. But people in their early years of investing can
also benefit from income-focused investing. By collecting after tax,
above-inflation income from investments providing significant
principal protection and reinvesting that income in securities also
providing after tax, above-inflation income, with significant principal
protection, investors can grow their wealth in a methodical way over
extended periods of time. Such a strategy might prove especially
fruitful in an economic- and inflationary-environment that one can
reasonably expect to be slow or below historical trends.

What specifically is the crux of income investing? Income investing

involves focusing your efforts on creating diversified streams of
income with as little risk to principal as you feel is possible in order to
sustain your purchasing power over time. Income investing involves
using your money to create more money in a way that is much more
predictable than putting all your eggs in one or two baskets and
hoping they grow over time. While it is true that strictly focusing on
capital appreciation over income can reap far greater rewards,
income-focused investing brings with it greater predictability and
greater certainty than capital-appreciation-focused investing does. I
do not believe one can ever achieve 100% certainty when investing.
But a strategy that makes planning for the future more predictable will
likely be an attractive option to many investors.

With that said, there is a role in the income-investor’s portfolio for

some securities that both provide income and theoretically allow for
unlimited capital appreciation. I will address those securities shortly.
But first, I would like to comment on macro-economic considerations.
 The Macro Picture - What Should Be the
Income Investor’s Focus?

The two greatest risks to the income investor are credit risk and
inflation. Making sure your portfolio is adequately diversified can help
you manage these risks, and following the broader macro
environment can help you monitor these risks.

In terms of credit risk, a weak economic environment will bring with it

challenges for businesses that could result in greater rates of debt
defaults and very weak stock prices. For a broad sense (not
company-specific sense) of how the economy is trending, I like to
monitor the labor market, manufacturing indices, retail sales, durable
goods order, consumer credit, and housing market data. I also keep
my eye out for other pieces of information that help build a well-
rounded, realistic view of the economy.

Concerning inflation, an investor whose portfolio is heavily weighted

toward fixed income, even if the yield is quite attractive, runs the risk
of longer bouts of moderate-to-high inflation eroding the purchasing
power of his or her investments. Inflation that remains contained at
lower levels makes it easier for income-focused investors to generate
after tax, real returns from their income streams. In terms of
monitoring inflation and the potential for inflation, I like to monitor
wages, income, consumer and producer prices, and again, consumer
credit. Of course, as someone interested in fixed-income, I also
monitor interest rates. But in my experience, the bond market has yet
to tell me something I didn’t already know about inflation. Therefore, I
monitor interest rates more from the perspective of looking for
investment opportunities rather than for unique insights into current
and potential future inflation trends. Also, the health of the labor
market can provide clues as to how future wage growth may trend.
Individual Common Stocks

There should be well-thought-out reasons for why each and every

security deserves a place in your portfolio. Regarding individual
common stocks, the primary reason I own them is for the potential
dividend growth. A secondary reason is for the potential capital
appreciation. I like to think of companies that have a history of raising
dividends on a regular basis as providing an income stream similar to
that of a variable-rate bond—except the rate, in many cases, rarely
goes down. Notice that I didn’t say I view my dividend stocks as bond
replacements. I know that calling certain dividend paying equities
“bond replacements” became popular in the financial community in
recent years. But common stocks carry risks that in my opinion do not
make them suitable bond replacements.

If you believe you should have X amount allocated to bonds, then X

amount should be allocated to bonds, not “bond replacements.” Why
exactly does dividend growth provide an income stream similar to a
variable-rate bond? This is because with each successive dividend
increase, the investor’s yield on cost increases. If you purchased XYZ
stock for $50 per share, and, at the time of purchase, XYZ was
paying a $1.50 annual dividend, your yield on cost and the stock’s
dividend yield would be the same, 3%. Fast forward 10 years, and
XYZ is paying a $2.50 annual dividend. The $2.50 dividend means
your yield on cost (your cost is $50 per share) grew from 3% to 5%.
Let’s jump another 15 years into the future, and XYZ is paying $6 per
share in annual dividends. Over the course of 25 years, your yield on
cost would have grown from 3% to 12%. Of course, things don’t
always work out that way. And it is the risk of things not working that
needs to be carefully managed within an income focused portfolio.

A secondary benefit to owning individual common stocks in an

income-focused portfolio is capital appreciation. To guard against the
risk of potential future inflation, it is necessary to have a component
of the portfolio that should benefit over time from rising prices. But it
is also necessary to not forget that capital appreciation is a secondary
concern. Should you get too aggressive in your stock selections, it
could harm your portfolio. When managing my allocation to individual
common stocks as part of my income-focused portfolio (distinct from
my trading portfolio), I do my best to ensure that one or more of the
following three things do not occur: (1) the portfolio is overly exposed
to equities, creating the risk of the next bear market causing me
significant hardship/changes to my standard of living, (2) one or more
of my individual stock selections goes terribly wrong, offsetting the
benefits to my portfolio provided by the other individual stocks, and
(3) my allocation to stocks underperforms the broader stock market
indices over extended periods of time.

Notice that in (3), I stated “my allocation to stocks,” rather than “my
allocation to individual stocks.” I own stocks in order to capture
dividend growth and as one method of helping to maintain the
purchasing power of my investments. And in case the allocation to
individual stocks provides sufficient dividend growth but
underperforms broader-market indices, I also have an allocation to
equity index funds. The primary purpose of also allocating money to
broader-market indices is to ensure that the correlation between my
equity portfolio and the broader-market remains no lower than a
minimum acceptable level.

Equity Funds

As I stated above, the primary purpose of investing in equity indices

within my income-focused portfolio is to maintain certain minimum
correlations with the broader market. If one of the reasons I am
investing in stocks is to protect my purchasing power, then I want to
make sure that at least some of my equity portfolio is guaranteed to
be correlated with broader-market indices. And the way to do that is
to purchase equity funds that track broad-market indices.
Furthermore, when purchasing equity funds, pay careful attention to
all the fees and costs associated with those funds. Fees can vary
greatly across different funds and fund families.

Additionally, I would like to point out that investors can also realize
rising yields on cost when investing in equity funds over extended
periods of time. But given the extremely unimpressive yields that
most broad-market equity indices currently offer, it will take a while for
your yield on cost to reach levels that many income-focused investors
would consider exciting.
Concerning Common Stocks, Keep This in Mind

Individual common stocks and equity funds have a role to play in the
income-focused investor’s portfolio because of the potential for
dividend growth and capital appreciation to protect purchasing power
over time. But investors should remember that common stocks are at
the bottom of the capital structure for a reason. An investment in
common stocks carries certain risks (and rewards) that other parts of
the capital structure do not carry. While it has been historically true
that stocks outperform other asset classes over very long periods of
time, it is important to remember that each of us has very defined
time horizons. Each of us runs the risk of growing old at an
unfortunate time in stock market history. How much you are willing to
risk that your time horizon won’t correspond with an unfortunate time
in stock market history will help shape your allocation to stocks within
your income-focused portfolio. Moreover, bear in mind that stocks
aren’t the only game in town. Bonds are also an important component
of any diversified income-focused portfolio.

Individual Bonds

When it comes to investing in bonds, my preference is to create a

diversified portfolio of individual bonds with the intention of holding
those bonds to maturity. I might not always hold the bonds to
maturity. But the original intention is to do so. Nowadays,
commissions and minimum purchase requirements are low enough
that a few hundred thousand dollars should be sufficient to build a
stable portfolio of individual bonds providing a real, after-tax yield,
without assuming an unreasonable amount of credit risk. Some
investors may scoff at the notion of realizing a positive inflation-
adjusted, after-tax yield in today’s interest-rate environment. But just
because that is difficult to achieve in one part of the bond market
(Treasuries, for example) does not mean it can’t be found in other
parts (corporate bonds and municipal bonds, for example).

Perhaps the biggest reason I prefer individual bonds over bond funds
is because absent a default by the issuer, the bond will mature at 100
cents on the dollar. The same cannot be said for most (but not all)
bond funds. The additional predictability that principal protection in
the form of holding to maturity brings for portfolio planning purposes
is something I find quite compelling. Other reasons I tend to favor
individual bond investing over purchasing bond funds is the ability to
manage which companies you have exposure to and the ability to
manage the maturity profile of the portfolio.

Bond Funds

If you decide to go the bond fund route, you will have the choice of
investing in defined-maturity funds (not that many currently available)
or more traditional funds. Defined-maturity funds are supposed to
give investors access to a diversified portfolio of bonds while also
having a set maturity date, like an individual bond does. Traditional
bond funds do not have defined maturities and therefore have more
interest rate risk over extended periods of time. Additionally,
traditional bond funds tend to maintain relatively constant durations,
whereas individual bonds and defined-maturity funds have declining
durations over time.

Although I am not a huge fan of bond funds, I can think of two

reasons why I might purchase one: First, if I want exposure to a
particular part of the bond market but am uncomfortable buying
individual bonds in or unable to adequately diversify in that part of the
market. Second, if I can purchase a fund with a low/short duration at
an attractive price (enough to provide what I consider a margin of
safety). Other than that, I am generally not interested in using bond
funds to build fixed-income exposure in my portfolio.

Additional Thoughts on Bonds

In order to maintain sufficient principal protection in the income-

focused investor’s portfolio, an allocation to bonds is prudent. The
allocation need not necessarily be focused on any one part of the
market (Treasures, corporates, munis, sovereigns, etc.). All of us will
have different preferences and different allocations. But the one thing
that should remain constant across all types of investors is that when
building a diversified bond allocation within an income-focused
portfolio, the importance of obtaining an inflation-adjusted, after-tax
yield should not be understated.

Investors using bonds to grow their portfolios can reinvest that

inflation-adjusted, after-tax income into more securities with real
yields, thereby maintaining consistently high returns from their bond
allocations (the word “high” is relative to the asset class under
discussion). On the other hand, investors living off their portfolios
need real yields in order to secure returns that help slow the pace of
withdrawals from their accounts or buy them time before withdrawals
become necessary.

Finally, as I mentioned earlier, while it has been historically true that

stocks outperform other asset classes over very long periods of time,
it is important to remember that each of us has very defined time
horizons. Furthermore, when thinking through how much of your
income-focused portfolio to allocate to bonds versus stocks, keep in
mind that each of us runs the risk of growing old at an unfortunate
time in stock market history. How much you are willing to risk that
your time horizon won’t correspond with an unfortunate time in stock
market history will help shape your allocation within your income-
focused portfolio.

Looking Beyond Stocks and Bonds

Preferred Stocks

Sitting just above common stocks on the capital structure are

preferred stocks. Preferred stocks are a hybrid-type security with
features similar to both common stocks and bonds. Investors looking
for higher yields than the common stock and bonds of a particular
company pay often find those yields in preferreds. Every public
company does not offer preferred stock, so your options are
somewhat limited. But many REITs, utilities, and financials do. For
investors looking to build annuity-like income streams, the yields
offered by many preferreds can be quite enticing.
Exchange-Traded Debt

In a recent article, “Exchange-Traded Debt – A Different Breed of

Bonds,” I noted several features of exchange-traded debt that makes
it unique. Unlike traditional bonds, debt traded on an exchange does
not have to be purchased in increments of $1,000, and there are no
minimum purchase requirements. On the other hand, exchange-
traded debt usually has very long-dated maturities and call features
that are less favorable than more traditional bonds’. Additionally,
exchange-traded debt is further up the capital structure than preferred
stock and pays yields that are generally in line with what one would
expect from preferreds. Again, investors looking to build annuity-like
income streams without needing to touch their principal often can find
attractive opportunities in the exchange-traded debt space.

Options

Despite their reputation for being inherently risky products, there are
certain options strategies that are suitable for most investors and help
enhance a portfolio’s income-generating capabilities. Two such
strategies are selling puts and selling covered calls. By using these
strategies to methodically collect small amounts of income on a
regular basis over extended periods of time, you can increase your
portfolio’s income stream in a meaningful way. If you want to learn
more about options, including selling puts, selling covered calls, and
other strategies, you can do so in my book, Options Strategies
Every Investor Should Know.

Real Estate

The illiquidity, leverage, and generally high minimum investments

often required for physical real estate investing keeps many people
from acquiring portfolios of properties in their lifetimes. If you are one
of the fortunate ones, you can certainly collect steady cash flows from
rental income. For everyone else, there is always REITs. Regarding
equity REITs, investors have plenty of choices in which to invest. This
includes both common stocks and preferred stocks. If you are an
income investor and someone interested in protecting purchasing
power over time, it may behoove you to have exposure to the real
estate cash flows of a variety of public REITs.