Income Investing

"Income investing" is the term used for investing which primarily focuses on generating income and only a secondary focus on capital growth.

There are several ways investors can generate income from their investments. They include dividends from stocks, interest (or coupons) from bonds or loans, rents from properties or other types of passive income such as royalties, patents, trademarks, copyrights or profits from private businesses. 

Who should focus on income over growth?

We think every investor's focus should be on your total returns, meaning income and capital appreciation added together. 

That said, it can be very difficult or impossible to predict your capital appreciation (especially in the short term) so income investing helps to give a more likely prediction of what cash you'll be generating. 

Income investing is likely to be especially important to investors who don't have other sources of income. 

The main example are retired people who do not have a job to supplement their income. 

A regular income from your investments is also likely to be beneficial to those with irregular incomes or those taking a break from work. 

Investors may also focus on dividend income as it provides "tangible" proof (cash payments) of their investment returns. There are also several studies such as that from Kenneth French  which show dividend stocks have outperformed non-dividend paying stocks over long periods of time.

Your income investing options

1) Bonds

Bonds are a type of debt instrument. Companies or governments issue bonds to borrow money and pay back a fixed annual coupon (interest) to the investors who buy the bonds. 

Secondary markets exist for bonds which allows investors to buy and sell their bonds. There are many different types of bonds and this topic goes beyond the scope of this page. 

The income from bonds is fairly easy to predict. Bonds have to pay a certain coupon on a specified date (if they don't they will probably be filing for bankruptcy). 

Your income from most bonds is fixed - hence the term fixed income. Thus, if you were to buy a bond at what is called "par" (also expressed as a price of 100 - where the bond is selling neither above nor below its purchase price) with a coupon of 5%, then you would know that you would receive an annual 5% return until maturity. 

The income from the bond doesn't change if the price of the bond changes. 

Let's assume that this 5% coupon bond drops to a price of 95 and has a 5 year maturity. Your yield (return) will increase to roughly 6%. This is because you will still receive the 5% of par value coupon and the bond will mature at a price of par (100). 

This means if you bought $9,500 worth of these bonds, you'd receive $500 a year in interest payments plus you'd get a capital appreciation of $500 as the bond matures at par. Of course, the inverse would be true if you purchased a bond above par value.

2) Stocks

Income investing normally has a large focus on stocks. Stocks provide income through their dividends. The dividend is paid from the firms profits and can fluctuate depending on the level of profits. 

Most large, blue chip companies try to grow their dividend gradually over time. The most famous examples of these are the dividend aristocrats who have grown their dividend for at least 25 straight years. 

Your dividend yield calculates your initial return in dividends from the purchase price. So if you buy a stock with a dividend yield of 4% and you purchase $10,000 of that stock then you can expect to earn $400 per year in dividends. 

If that dividend grew by 10% the next year then you would receive $440 in that year. 

The main advantage to dividends over coupons is their ability to grow over time. This can help increase the purchasing power of your income over time and help to protect you against inflation. 

If the dividend continues to grow over time then it is likely that the capital value will grow as well (although this is not guaranteed). In the above example, if your initial dividend yield is 4% and the dividend grew by 10% a year, then your dividend would have doubled in just over 7 years. This means that for the stock to still be yielding 4% then the stock price would need to double as well. 

For more ideas on income investing on stocks, see our page on the advantages of dividends.

3) Property

Income investing from property means focusing on the income you receive from rents. 

Unlike bonds, over time you should be able to at least increase rents with the inflation rate which would protect your real (inflation adjusted) income, although this may depend on you upgrading the quality of the property. 

In a similar way to stocks listed above, if you can increase the rents over time then this should help with capital value appreciation. Capital appreciation can also come with the ease at which people can obtain credit (mortgages), and the local demand and supply of properties. 

You also have an advantage in income investing in property. Borrowing against the value of the property in the form of a mortgage can leverage the value of your investment. Usually you only need a down payment (deposit) against the property, so you can spread your investment over several properties. 

Unlike borrowing on margin (how you borrow for stock purchases), banks generally don't demand extra payments if the value of your property goes down. That said, if you fail to keep up with the scheduled payments then the property can be repossessed. 

The drawback to living off the rental income can be void periods if your tenants leave and the potential for constant spending (such as for heating / AC systems, toilets, furniture etc.) that is required to maintain the property.

You can have an agent manage your property but this - of course - means more cost.

4) Royalties

You can earn a royalty when you own an asset (you either created or bought the asset) and let someone else use that asset for their benefit. 

The party that is using the asset is usually known as the licensee and the asset owner is known as the licensor. Usually a pre-agreed payment (such as percentage of revenue) is agreed, along with other terms, in the license agreement.   

Typical example of royalties payments are to patent owners (such as drug companies), copyright owners (such as authors), franchise owners, music composers, or resource owners. 

So if bought your local McDonald's franchise, then you would have to pay a royalty on every Big Mac sold back to the parent company (McDonald's) as a condition for you selling those Big Macs.

5) Private businesses

Income investing could mean purchasing (or starting) a business. 

For this to be passive income, you would have to put the business under management, leaving the day-to-day running of the business to someone else. 

In many ways, this is like purchasing a stock but, in this instance, you would likely have a controlling stake which means you can exert more control. This means, you could fire the management, make them send you the excess cash, sell the business on your own terms or set the dividend rate. 

You are also likely to be able to purchase a private business more cheaply (on an earnings multiple and asset basis) than a stock on a public market due to the illiquidity of the asset. You can probably also obtain financing against the assets or the cashflow of the business. 

In the internet era, starting your own business need not be as daunting as it once was. Programs and tools such as Solo Build It (the system we use to manage our websites), can make it a reality for anyone to start a successful business, without huge capital investment. Click here for more information.

In summary...

As you can see, income investing can take many forms and in an ideal world you would be able to earn from all of the above examples. 

It's important to know about all the options because then you can compare the value you are getting from one possible asset to another. There are times when one asset class as a whole can look like very poor value (such as stock in the late 1990s, or bonds at the moment). You certainly need to do a lot of research before purchasing any asset but over time your goal should be to build a collection of these types of assets that will (hopefully) sent you a consistent flow of cash while you get on with your life. 

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Mike - six-figure dividend earner

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