Building an Income Portfolio (the Ultimate Guide)
There’s more to building an income portfolio than investing in dividend stocks or real estate. A lot more.
In this Ultimate Guide, we will cover the most important aspects of building an income portfolio:
- The best types of income investments (hint: there’s 7 of them, all of which I invest in)
- Comparing the best income investments
- Determining your income portfolio strategy
- Establishing your income portfolio allocation
- Building an income portfolio for monthly income
If you’ve read my previous post on Why invest for income?, then you already have some insights on the benefits of building an income portfolio. If you haven’t, I encourage you to do so.
Now that you an idea of what to expect from the Ultimate Guide to Building an Income Portfolio, I suggest you make yourself comfortable. Let’s dive right in!
The 7 best types of income investments
There are many different types of dividend paying equities and fixed income investments that can be used to build your income portfolio. In this section, I will go over the best types, all of which I invest in:
- Dividend stocks
- Physical Real Estate
- Real Estate Investment Trusts (REITs)
- Preferred Shares
- Bonds
- Closed-End Funds (CEFs)
- Peer to Peer (P2P) Lending
I will not go over savings accounts and Certificates of Deposits here mainly because I don’t consider them income investments but rather as a way to efficiently park cash (and at low yields nowadays).
And without further ado, let’s dig into the 7 best types of income investments.
1) Dividend stocks
Dividend stocks need no introduction right?
If you’re interested in building an income portfolio then you’ve probably heard that one of the best way is to invest in shares of companies that pay dividends. Typically you can invest for income through dividend stocks in several different ways:
- High dividend growth stocks – with a focus on those with a track record (10 years or more) of above average dividend growth. They typically have a lower yield but provide greater capital gains.
- High yield stocks – where the focus is on immediate income, typically at the expense of dividend growth (you should still seek a long track record of sustainable dividends that grow at least at the rate of inflation)
- Dividend ETFs – for instant diversification and a hands-off approach. Yields are usually lower then if you hand-picked your investments and total dividends received will so it’s harder to control your income stream.
Predictable income, with growth on top? Yes please!
High dividend growth stocks and high yield stocks, if picked correctly, ensure a stable, predictable and growing income stream. It is not as easy to find these characteristics in ETFs, even dividend growth ETFs.
There’s a reason why many investors in the investment community focus on a dividend investing strategy. It is a proven way to long term wealth through the combined compounding power of both dividend growth and reinvesting the dividends.
Once you invest, you collect growing dividends over time, reinvest those growing dividends and thus growing your dividend income stream even further. Rinse and repeat, continuously.
On top of that if you keep funneling in new money into your accounts then at some point you’ll look at your portfolio and notice that you’ve built a compounding machine! The power of the Snowball Effect cannot be understated.
Another great reason to invest in dividend stocks, and stocks in general, is that analyzing them is incredibly stimulating, intellectually at least. You get to enjoy the process of gaining a deep understanding of companies and industries, their changing dynamics, business models, etc.
You start understanding business, holistically. I love it!
Research, research, research
Unfortunately, it’s not all rainbows and butterflies.
The main disadvantage with individual dividend stocks is that it does take quite a bit of time to research stocks (read annual reports, listen to conference calls, etc.). You must have a passion for it and some time to dedicate to it, consistently.
And even when you do, you still have the (quite high) risk of under-performing passive indexes over the long term.
If you don’t love the research, don’t have the time, or not willing to risk under-performing, then I propose you stick to broad based equity ETFs such as those tracking the S&P 500 or MSCI World indexes. They pay dividends too after all, but the yields may disappoint you.
Alternatively, some carefully chosen dividend ETFs would also do the trick if you want a higher yield.
2) Physical Real Estate
One of the most famous ways to invest for income is to buy a property and rent it out either to long term tenants or short term tenants (e.g. AirBnB). Investing in physical Real Estate is a less passive type of investment because you need to find the right property, find tenants, deal with tenant issues, do repairs, etc. Doesn’t sound like much fun does it?
On top of this, it can take a while to save up the sizable deposit you need and let’s not forget to mention the nosebleed transaction costs and illiquidity.
For full disclosure, I’ve purchased my personal residence and I’ve rented it out in the past for shorter periods. It’s the only physical real estate I own.
Real advantages
The main advantage of investing in physical real estate is that you can use a lot of cheap leverage and this can deliver exceptional returns if you buy correctly.
Investing in physical Real Estate also usually provides unique tax advantages due to interest and depreciation deductions from taxable income.
Physical Real Estate is a good inflation hedge and you can generally expect your rents to grow over time.
As an added bonus, you don’t get to see the price of your home change every second on a daily basis. Perfect for minimizing the temptation to stray off the long term investing track!
Can touch this
However, most important and unique of all, for me at least, is the fact that real estate is tangible, a real asset. Definitely worth owning for this reason alone.
Don’t forget though that if you’re investing for income, then your rental properties should deliver positive cash-flow to you, every month, net of all expenses! Do you factor in long term reparations or renovations in your calculations? Yes, that includes the super expensive roof, even if it’s new.
3) Real Estate Investment Trusts (REITs)
Real Estate Investment Trusts are essentially regular stocks that invest in real estate. The key difference is that they are required by law to distribute at least 90% of taxable income as dividends to investors. Investing for income anyone?
I use U.S. REITs or European real estate stocks to increase my exposure to real estate. It’s probably also to overcome my frustrations of not managing to buy any more attractive rental income property.
Wait, did someone say rental income property?
Are REITs right for you? They’re pronounced “REET” by the way
REITs are awesome because they are passive relative to physical real estate. It just takes a little bit of research behind your screen. But just like dividend stocks you do need to know what you’re doing and they do require a somewhat different type of analysis and understanding of terminology.
They are typically less correlated to regular stocks, providing a good diversification benefit.
You can invest in many different types of REITs. The list is almost endless: residential, hospitals, shopping centers, warehouses, hotels, data centers, amusement parks, cell towers… you name it!
Why wouldn’t someone want to own shares in a company that owns thousands if not hundreds of thousands of properties diversified across regions and sometimes even across types of real estate assets?
Good REITs are also able to amortize the management overhead across a huge portfolio, which is more cost effective than Mr. Retail Investor hiring their own property manager. Always privilege internally managed REITs (versus externally managed REITs that outsource their core business!).
REITs use leverage too in case you were worried that you would miss out on the leverage benefits of physical real estate. Don’t forget though, that leverage works both ways.
REITs typically use a lot less leverage than individual physical real estate investors. Maybe it’s because they think it is reckless to borrow 80 to 90% of assets’ value? Food for thought!
Raising money, constantly
The main disadvantage of REITs is that, because they are required to distribute most of their income, they keep very little cash on hand. They rely on constantly raising equity or debt, either to repay debts or grow their portfolio.
If share prices are low during a market crash and banks are afraid to lend, then you better hope that your REITs do not have a huge debt repayment deadline looming. You should definitely watch those debt maturities, your REIT’s ability to raise funds and to withstand a crisis.
Generally though, I do love investing in REITs because the business model is easy to understand, real estate is everywhere and the higher, inflation protected, income is definitely most welcome.
A special thank you to European Real Estate stocks and particularly to Vonovia that allows me to be part owner of 100s of thousands of apartments across Germany, Austria and Sweden.
4) Preferred Shares
What if I told you that you could get your dividends paid as a priority to regular dividend investors, that those dividends would be safer as a result, less volatile and that you would get a high yield for the trouble?
Hello preferred shares!
Preferred Shares are somewhat of a hybrid security sitting after bonds but before ordinary stocks in the capital stack. While they are considered an equity, they have characteristics much closer to bonds and other fixed income investments.
It’s all about balance
Preferred shares are kind of like the perfect balance between income, safety and stability.
They offer a high and stable income and many of them are cumulative meaning that if a company stops paying dividends on its preferred shares, then no ordinary shareholders will receive dividends until preferred stock holders have been fully compensated.
Preferred shares of REITs are one of my favorite types of investments because REITs, as I mentioned earlier, are required to pay a high percentage of their net income to shareholders by law and their preferred shares are typically cumulative. What a great combination!
Generally, if you do the right research, you can identify preferred shares, particularly REIT preferred shares, where the risk of not getting paid is incredibly low.
Look for a deal
Preferred shares are typically issued at 25 dollars par value and trade freely at market prices on a stock exchange (typically the NYSE). The price of a preferred share trades deviates from its par value and it is really easy to see if you’re buying them at a discount or premium.
Generally, I avoid buying preferred shares unless they trade a discount, sometimes if I’m struggling to find an investment, I will consider investing in a high quality preferred share at a very slight premium.
Too good to be true?
Preferred shares do have a major drawback though. Oh yes, there’s always a drawback in any type of investment.
They carry interest rate risk and many preferred shares are perpetual, meaning that they never mature. The majority have a call feature though, which introduces call risk.
This means that the company have the option, but not the obligation, to buy back the shares after a certain call date (usually just a few years after issue).
Unfortunately, the company will probably not buy back the shares if you would benefit from them doing so (e.g. when interest rates are rising so you could reinvest the money at higher yields elsewhere) and will exercise their call option at the call date when you would not want them to do so (e.g. when interest rates are falling, because then you will not be able to reinvest at a similar yield, all else being equal).
For this reason and this reason alone, you should not have a huge allocation to preferred shares.
Individual preferred shares are quite tedious to research (for free at least) because information on them is less prevalent and they are a relatively under-followed. On the positive side, this will help you keep your allocation in check.
5) Bonds
When you buy bonds you essentially become a lender to a company or government giving you the right to receive interest from them.
There are many different types available, government bonds, municipal bonds or corporate bonds. And you can gain exposure across different geographies, duration and credit quality characteristics.
Safety first !
Bonds are the safest part of the capital stack and creditors, those who hold the bonds, are always prioritised over preferred and ordinary shareholders when it comes to claims on a company’s assets.
Bonds pay interest rather than a dividend. They are also a lot less volatile than stocks and are somewhat less correlated providing portfolio diversification benefits.
It’s therefore no surprise that the conventional wisdom says that you should invest more and more of your portfolio in bonds as you get older.
Bonds have the same characteristics in terms of trading at discount or premium to par and being impacted by interest rate risk and call risk as I described for the preferred shares.
Check maturity and duration
One of the differences though is that the majority of bonds have a maturity date. This means that when you buy them you have an exact idea of by when your principal will be paid back at the latest. So you should always buy bonds and be prepared to hold them to maturity.
I avoid buying long duration bonds because interest rates are currently very low and the price of the long duration bonds will be destroyed in a rising rate environment.
To bankrupt or not to bankrupt?
Unlike for stocks, in bonds you don’t need to make an educated guess on valuation, future revenue growth and profits if you want to come out on top.
If the company or government does not go bankrupt then you make some money but if it goes bankrupt then you lose big!
That’s also why I generally favor investing in bonds with shorter maturities, it’s much easier to predict likelihood of bankruptcy in the short term versus the long term. Especially in this day and age.
Watch those balance sheets and debt maturities and try to make sure that the bond has better characteristics, when compared to issues of the same credit rating.
Hide and seek
While bonds are quite easy to analyse, it is quite painful to find suitable bonds to invest in. Most companies and governments have many different types of bonds you can invest in, and bond research and screening tools are hard to come by (in Europe at least).
Many of the highest quality bonds have a minimum investment threshold of 100s of thousands of dollars or euros so you also need to spend effort to identify those that are affordable.
Typical bonds don’t trade on an exchange so you rely on the Over the Counter trade. This also means that they are less liquid than stocks and that trading costs are often higher as a result.
When choosing your stock broker, you should ensure they also have access to a good inventory and, ideally, a good bond screener.
Many investors choose to invest in bonds through ETFs, because it’s easy and hands-off. Like for stock ETFs though, the interest you will gain will be quite unpredictable over time.
6) Closed-End Funds
Closed-End Funds (CEFs) are very interesting vehicles and one of the investment types that provide the highest yields!
CEFs are a type of investment company (like Mutual Funds and ETFs) that hold a portfolio of assets (equities, bonds, options, senior loans, mortgages, you name it!)
So familiar, yet so different
CEFs are actually very similar to ETFs in the sense that they provide instant diversification, trade on a stock exchange and you can buy them through your broker. Similarly, their prices change throughout the day.
There are some key important differences though.
CEFs have a very different structure to ETFs and Mutual Funds in the sense that once they issue shares, there is typically no more issuing done (it’s similar to a stock IPO).
Did you know that ETFs and Mutual Funds employ mechanisms to ensure that the ETF or Mutual Fund prices always trade at a price that is very close to the Net Asset Value of the underlying holdings.
If supply and demand forces start resulting in a deviation to NAV, the ETFs or Mutual ETFs will intervene to redress this.
With CEFs, investors trade directly with each other and prices always reflect supply and demand from investors.
This means that you can buy or sell CEFs at a premium or discount to Net Asset Value of the underlying holdings (a bit like the discounts to par on bonds or preferred shares).
The assets best suited for CEFs
CEFs are also suited to holding less liquid assets as well as those that could benefit from active management (more than regular stocks at least, for which it is proven beyond doubt that passive is investing is generally superior).
I actually use CEFs instead of ETFs to invest in bonds and preferred shares because I believe in the value of active management for this type of less liquid asset (many individual issues also trade at a premium due to the interest rate environment, so it pays to be selective).
It also allows be to diversify across different investment vehicles and benefit from the unique characteristics of CEFs in my portfolio.
Hello leverage, my old friend
It’s important to know that most CEFs use leverage, which is also a unique way to get some leveraged exposure to the underlying asset class. Which is better? Investing in a high yield junk bond ETF or in an investment grade bond CEF which provides the same return due to 30% leverage?
You could also do both! Wouldn’t that be even safer?
Are high expense ratios ever OK?
Most CEFs have high expense ratios but this is OK for well managed CEFs. The distribution yield you see is net of these expenses and usually a big chunk of the expense ratio is for interest expense (which is really a benefit if the leverage is employed correctly).
If you use CEFs to invest for the same reasons as I do (i.e. for less liquid assets and not for equities), then the expense ratios are arguably worth it. Net of interest expenses they are comparable to many mutual funds.
CEFs are quite special
I love CEFs because if you do your research right, you can find CEFs:
- with a long track record of stable Net Asset Value and distributions,
- that trade at a discount, juicing returns
- that employ a prudent amount leverage, further juicing returns
- that beat their passive ETF counterparts (history is not a prediction of the future, but still right?)
- that play a unique role in your portfolio
- And that provide a great yield!
The main drawback is that they are more volatile due to the leverage and high payout but it’s manageable and worth it for me for the high yield. CEFs are riskier than ETFs and not all CEFs are created equal so tread with caution and do not allocate too much to them in your portfolio.
7) P2P Lending
Peer to peer lending is a relatively new asset type allowing you to invest small amount of money across a large volume of consumer loans, startup loans, real estate development loans, etc.
P2P lending is particularly popular among millennial European investors who are attracted by the high yields and easy access. Yields in the US are considerably lower but this reflects the relative safety and maturity of the US platforms.
I invest in peer to peer lending because I am passionate about Fintech (I started investing in P2P in 2015) and as a further diversifier. OK fine, you got me, I’m attracted by the high yields too.
As opposed to my investment portfolio, my peer to peer lending portfolio aims to be as concentrated as possible into the most financially stable platforms (yes I look at their financial statements).
And even then they’re a big risk so I’ll keep them to under 5 percent of my portfolio.
Blink first, and run!
Tread with caution, they are the riskiest asset class and make sure to do regular research on the financial stability of the platforms and any intermediaries. I recommend always favoring the highest credit rating tranches (at the expense of a bit of yield) and to bolt for the exit at the first sign of something going wrong.
I have luckily avoided major disasters because I got out at the first sign of trouble but I maintain some exposure while being fully conscious that I may lose it all. You have been warned.
Comparing the best income investments
Now that you have an overview of the 7 best types of income investments, let’s compare them in the context of building an income portfolio. What do they bring to the table?
The comparison table present below is based on my personal views regarding how I consider these income investments as I build my own income portfolio. This includes a self-assessment of my abilities to pick the right investments for each different type.
Per asset class / investment vehicle, I try to ensure that the above guidelines that I have set for myself are met, on average.
This means that each individual investment will not necessarily meet these criteria.
I hope that you now have at least a general idea of what the different types of income investments could bring to your income portfolio.
With that said, let’s go one step deeper!
Determining your income portfolio strategy
Before diving into building your income portfolio, it’s important to reflect on your income portfolio strategy.
Answering the following questions is a very good start:
- What do I want to achieve from my income portfolio?
- How much of my portfolio do I want to allocate to income investments?
- How much price volatility can I accept? How much income risk can I accept?
- Do I want my income portfolio to focus more on income growth or on current income?
- What yield level do I want to target? Is it realistic in the context of the above?
- What is my tax situation with regards to dividends and interest income?
- Based on the above and my existing knowledge / willingness to learn, which asset classes do I want to target?
A portfolio strategy is incredibly personal and should reflect your life and investment goals. By answering these questions and taking a bit of time to reflect, you will, at the very least, have some guidance to help you determine your income portfolio allocation.
This will naturally start putting your portfolio strategy into action even if everything is still not crystal clear in your head.
Establishing your income portfolio allocation
Once you have some clarity on your income portfolio strategy, the next step is determine what percentage of your portfolio you want to allocate to which type of income investments.
You should simulate the overall expected yield and income growth of your target allocation and develop your own view of overall portfolio and income risk.
Adjust the numbers and allocations until you end up with something that you are comfortable with and that seems realistic to you. In case of doubt, be conservative. You want your portfolio to under promise and over deliver!
You are now ready to start selecting investments in a way that is consistent with your income portfolio strategy and target allocation.
I suggest that you do so step by step and always based on your own investment research and individual situation.
Building an Income portfolio for monthly income
Ideally, everyone would prefer if their portfolio would generate a relatively consistent amount of income every month as it’s easier to match the income with monthly expenses.
However, as you know, many dividend stocks and REITs pay quarterly dividends. Preferred Shares also typically pay dividends on quarterly basis. Many bonds on the other hand pay interest annually or semi-annually.
If you want to tailor your income stream for monthly consistency, you optimise around the quarterly payment patterns of dividend stocks, REITs and preferred shares:
- January, April, July, October
- February, May, August, November
- March, June, September, December
This means that you would privilege investing in stocks that pay dividends on months where you are currently receiving less income on average.
There are certain REITs that pay monthly dividends, the most famous being Realty Income (O), the monthly dividend company. Some Business Development Corporation (BDC) stocks such as Main Street Capital (MAIN) also pay monthly dividends.
Also, many CEFs, and all of the ones I invest in, pay monthly dividends. Some ETFs pay monthly as well.
Personally, while I do appreciate monthly payers, I do not go above and beyond to try and optimise my portfolio for monthly income. At least not in this stage of my investment journey.
I prefer to focus on finding the right investments at the right prices, which is challenging enough as it is, without adding income timing constraints.
And, with that, we conclude this Ultimate Guide! Wow, it’s a lot longer than I expected when I started writing . I hope you enjoyed and learned from it. I’ll be sure to update and improve it over time as the environment and my income portfolio evolve.
Thank you!