You can classify investors into two basic types. There are those who want appreciation - that is, they invest for growth. And there are those who ask of their assets "show me the money - now."
We call the latter type income investors. Income investing involves building a portfolio using dividend-paying stocks, bonds, real estate, and other assets designed to generate cash on a recurring basis.
With income investing, once you buy the asset, there isn't a whole lot more to do. This is buy-and-hold passive investing at its best. There are multiple types of investment income assets, and ways to invest for income. Here's a rundown of the most common.
1. Dividend stocks
What they are: Dividend-paying stocks are issued by companies that make cash payments per share, generally quarterly, based on how well the company is doing. The two main types of dividend stocks are called common and preferred.
How they work: Common stock dividends are set by the company's board of directors each quarter. You won't know the amount or even if there will be a dividend until the board decides.
Preferred stock dividends are more regular: pre-determined, fixed payments over a specified period of time. Also, preferred stockholders receive their dividends before common stock shareholders get theirs.
Although common stock dividends are riskier, you stand to gain more. Preferred stock dividends are less risky, but generally lower.
What to know: The most consistent, good dividend-payers tend to be from blue-chip stocks - that is, those of large, well-established corporations.
How to tell if a dividend is a good one? Look not just at the dollar amount, but at the dividend yield: that is, the company's annual dividend divided by its stock price and multiplied by 100. (It's often indicated on a stock's online listing.)
Aim for stocks that pay a 2% to 6% dividend yield. That ratio indicates a decent payout relative to a company's earnings and market valuation and helps you avoid companies that may be borrowing excessively to inflate their dividends.
What they are: Bonds are loans to the government or a company. Your income from bonds comes in the form of fixed-interest payments. As the bondholder (lender) you receive a fixed amount of interest income on a regular schedule. When the loan term ends, you receive your original investment back.
How they work: The rate of interest you receive on a bond depends on the length of its term - the longer, the higher - the creditworthiness of the borrower, and the conditions of the market. There are three main types of bonds:
- Government bonds, also known as Treasuries, are considered extremely reliable because they are backed by the US government, but the tradeoff is a relatively low interest rate.
- Municipal bonds are a form of government bonds issued by states, cities, counties, and other government entities. Interest is exempt from federal taxes and often from state and local taxes as well.
- Corporate bonds are issued by companies (both public and private) and therefore riskier than government bonds. For that reason, they pay a higher interest rate than government bonds. depending on the creditworthiness of the issuer.
What to know: Bond prices tend to go up when the stock market goes down, making bonds a good tool to balance risk from equities, as well as an income source.
3. Real estate
What they are: Although it can and does appreciate, real estate often provides a solid cash flow as well. The income derives from rents paid by tenants of residential, industrial, or commercial properties, and sometimes from mortgage interest on the properties as well. You don't have to become a landlord: REITS and RELPs are common ways to invest in real estate indirectly.
How they work: Real Estate Investment Trusts (REITS) let you buy shares in a publicly traded company, which pays dividends to you much like stocks. The dividends can vary in both amount and frequency. REITs invest in a variety of projects and are considered ongoing, long-term investments.
A real estate limited partnership (RELP) lets you pool your money with other investors to buy or develop real estate properties in a private (i.e., not publicly traded) investment. Formed to operate for over a period of years, a RELP offers excellent dividend payments annually, though the big money comes via distributions when the projects are complete and sold towards the end. As with a REIT, a RELP pays fluctuating dividends based on the type of real estate investments it makes.
What to know: Dividends in both cases are not fixed but can vary, depending on the profit/rent income received by the REIT or RELP. You stand to gain more with a RELP over a specific, shorter period of time than with a REIT. However, because they don't trade on public exchanges, RELPs can be harder to unload; REITs are much more liquid.
4. Money market funds
What they are: Money market funds (MMFs) are a special type of fixed income mutual funds that invest in short-maturity, low-risk debt securities that pay dividends like most other income-producing investments.
How they work: MMFs are low-volatility investments that may be taxable or tax-exempt, depending on the types of securities held. MMFs operate on the net asset value (NAV) standard, meaning they attempt to maintain a share value of $1. Any excess is distributed as dividends.
What to know: Investors like the NAV standard because it forces fund managers to make regular dividend payments to investors, which provides that steady cash flow income investors prize.
5. Certificates of deposit
What they are: Banks also sell income-producing products that many investors include in their portfolios because of their relatively low risk. One of the most common is certificates of deposit (CDs).
How they work: Certificates of deposit (CDs) are a type of savings account that come with terms ranging from six months to five years. The longer the amount of time you must keep your money in the CD, the higher the interest rate.
What to know: If you want income (interest) from your CDs, most banks will let you take it out as it is earned at its fixed rate. Your principal, however, is usually locked in for the duration of the CD.
6. Money market accounts
What they are: Money market accounts, sometimes called money market savings accounts, are another common bank product. They pay higher interest than regular savings accounts, but have more restrictions and often require a higher initial balance to get the best interest rate.
How they work: You can make withdrawals (including interest) from your money market account up to six times a month.
What to know: Money market accounts (and CDs too) are not considered major income investments, but rather savings vehicles. Still, they do earn some return, and of course, are highly liquid: Access is as close as the nearest bank branch. And both are FDIC-insured.
What they are: Annuities are contracts sold by insurance companies that make regular payments to you for a set period or for life. You invest an initial sum, then the money is repaid to you in periodic installments, a process known as annuitization. The payments typically consist of both principal and interest.
How they work: The three main types of annuities are:
- Fixed, which pay a set interest rate
- Variable, whose interest rate fluctuates, depending on the investments (usually mutual funds) you choose
- Indexed, which provide a return based on an index, such as the S&P 500.
The risk depends on the underlying stability of the insurance company and the type of annuity: Fixed is the least risky and variable the most.
What to know: Compared to other types of investments, annuities are often criticized for high fees and expenses.
The financial takeaway
Income investing is often associated with older, often retired investors: Common financial wisdom often has portfolios shifting from growth to income as their owners age. Still, all investors can and should include some income producers in their portfolio - as a counterbalance to aggressive growth assets, if nothing else.
Generally speaking, the more risk you are willing to take or the longer you are willing to let your money work, the higher rate of return you will receive.
That said, the main purpose of income investing is to produce cash flow with a reasonable amount of risk. Income-producing stocks, bonds, and other securities are meant to be the stable foundation of your portfolio. You can always diversify your risk further by investing in income-oriented exchange-traded funds (ETFs) and mutual funds.