HOW THE INCOME INVESTING STRATEGY WORKS.

When you establish your investment portfolio, your firm will ask you to identify the investing strategy you want to incorporate. You'll be able to select from a pre-existing checklist that might include strategies such as capital preservation, growth, speculation, and income. This is known as an investment mandate, and your portfolio managers will work to invest according to the mandate.

Income investing is a type of investing strategy that is designed to generate funds for you to live off of. There are many different types of stocks, bonds, ETFs, or other investment instruments that can be used for this strategy—it is beneficial to understand how the strategy works and the methods you can use to generate income.

Income Investing Strategy and Objective

The income investing strategy involves putting together a portfolio of assets specifically tailored to maximize the annual passive income generated by the holdings. The reason investors put together an income portfolio is to produce a constant stream of additional cash.

Picture a teacher who earns $40,000 and is married to an office manager earning $55,000, together making $95,000 before taxes. Now imagine they somehow come into $1 million. By going with an income strategy that produces, say, 4% annual payouts, they can generate $40,000 in income from their portfolio each year, which increases their household income to $135,000.The $1 million would serve as a sort of family endowment, much like an educational fund; money that is never spent but devoted solely to producing spendable funds for other purposes.

This strategy is especially popular with retirees who need extra cash to fund their living expenses. Income generated from the portfolio can be used to pay bills, buy groceries, purchase medicine, support charitable causes, cover tuition for a family member, or any other purpose the investor sees fit.

Types of Investments Used to Construct an Income Strategy Portfolio

The specific asset allocation of an income investment portfolio will vary, but all investors need to make sure they have diversity throughout their assets. Income strategy portfolios generally contain safe, dividend-paying blue-chip stocks with conservative balance sheets and a history of maintaining or increasing dividends per share—even during rough economic times.

Coca-Cola and Disney are examples of blue-chip stocks. Bonds and other fixed-income securities, including Treasury bonds, corporate bonds, and municipal bonds may be appropriate depending on the tax characteristics of the account. For example, you would never hold tax-free municipal bonds in a Roth IRA or other tax shelter under almost any circumstance.

Real estate—including property ownership and real estate investment trusts (REITs)—is also commonly found in an income investment portfolio. REITs are riskier than most income investment portfolio assets because they are susceptible to market changes, but a well-purchased REIT can create substantial wealth.

Master limited partnerships (MLPs) are special publicly traded limited partnerships that can be bought on exchanges like stocks. Businesses owned by MLPs do not pay federal or state income tax; individual investors are responsible for paying the taxes owed on their portion of the income. Because of the tax savings, these businesses generally pay out higher dividends to investors, making them a lucrative choice for income investment portfolios.

Cash reserves, often consisting of FDIC insured checking and savings accounts and U.S. Treasury bills, are the only acceptable large-scale cash equivalent when absolute safety of principal is non-negotiable.

Ideally, an income strategy portfolio will have enough cash on hand to maintain at least three years’ worth of payouts if the other assets stop generating distributions. When interest rates are ample relative to inflation, money market accounts, money market mutual funds, and their alternatives can be a great place to park surplus funds.

Advantages and Disadvantages of Income Investing

The biggest advantage of opting for this strategy is that you provide yourself an additional source of income. The income may be modest, but it is generally reliable and requires little to no work—if added to other income streams, you can increase your monthly cash inputs and live that much more comfortably.

The one notable disadvantage is that you forego the benefits of compounding interest because earned income is paid out instead of reinvesting. Imagine you construct a portfolio with an initial value of $100,000 that produces 5% annual payouts; over 10 years, you will make $50,000.

If the payouts were to be reinvested instead of withdrawn, you would make $62,889 over that same period. Additionally, it’s much more difficult for an income strategy investor to take advantage of concepts such as deferred tax leverage, where you leave your capital invested to continue gaining interest, rather than paying hefty taxes upon withdrawal or transfer.