Income investing is an investment strategy wherein the goal is to buy investments that will pay an ongoing income. Though the concept is simple, achieving success can be trickier because the strategy requires a lot of research to find the most consistent, reliable, high-paying income investments. As with most other investing strategies, income investing will be more successful if the investor has a diversified portfolio. Diversification increases the probability that the investor will retain an income stream if one sector is down and the investments within that sector stop paying income – if the entire market is down, diversification is less effective in retaining investment income.
There are several ways an investment can produce income. Below are some of the primary sources of investment income:
1. Interest: Bonds, bond funds and money market funds generally pay interest.
- Depending upon the structure, interest rates could be fixed or variable.
- Bonds and bond funds often pay interest twice yearly.
- Money market funds often pay interest monthly.
2. Dividends: Many stable, profitable companies pay dividends to their stockholders.
- A company board of directors determines a dividend amount, usually based upon company profits and performance.
- Dividends are paid per share – for example, at $1 per share someone who owns 1,000 shares would receive $1,000.
- They are a means of enticing investors to buy a stock that is not rapidly gaining value.
- Dividends can come in the form of cash or stock.
- Equity Income mutual funds and similar ETFs are geared toward selecting stocks that will pay dividends and provide an income to fund holders.
3. Capital gains distributions:
Mutual fund managers buy and sell stocks within funds on an ongoing basis. When funds sell stock with a gain, they have to distribute the gains to fund holders in order to avoid capital gains taxes at the fund level. Consequently, mutual fund holders can receive yearly cash payouts called capital gains distributions. For further explanation of capital gains distributions, see our article about capital gains.
4. Real Estate:
- Real Estate Investment Trusts (REITs) are a means of gaining real estate income without directly purchasing real estate
- owning physical property can produce income, like rent payments or farm profits
Using Income Investing
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Successful income investing means the investor buys securities or other investments that consistently pay higher income and maintain a steady or slightly-increasing share price. If an investor achieves this (difficult) balance, he/she can collect income without losing the principle of the original investment. At some time in the future, the investor could sell the investment and recoup the original principle and possibly a small capital gain.
Some people choose to use income investing as a major source of income, particularly during retirement. This strategy can be a great way to generate income and preserve principle, but it’s risky to rely on investment income as your primary source of retirement income. When the market cools down, even if the underlying investment maintains value, income payments will likely be reduced or eliminated.
Ultimately, income investing has a place in a diversified retirement plan when used in conjunction with employer-sponsored plans, IRAs, annuities and more liquid investments.