Why invest for income? (the 5 most important reasons)
Everyone should invest for income and yes, that includes you.
You might be asking yourself, especially if you’re a budding millennial investor, “why invest for income when I can invest for growth or total return?”
In this article I explain the 5 most important reasons why you should invest for income regardless of your life situation.
This does not necessarily mean going “all-in” on an income investment strategy, but to have at least part of your portfolio allocated to income investments. This is because it will help you:
- Stay motivated
- Prepare for the future
- Control your income stream
- Get better value for money, and
- Take advantage of the tax code (counter-intuitive indeed)
Having first started investing only in broad market index funds, I realized, after a lot of research, that investing for income had to be part of my strategy. Since then, and several years later, I am more convinced than ever…
1) Stay motivated
The key to success in investing is having the discipline to stick to your investment strategy through thick and thin.
You see, investments are volatile and fluctuate widely, even over very short periods.
It can be quite nerve-racking and demotivating to invest your hard earned savings for months on end when suddenly the market takes a hit and you realise that your portfolio has not delivered any gains (or even worst, is showing a loss) on the money you have been funnelling in.
When you invest for income, you will naturally have a shift in mind-set since you will have an alternative data point to focus on. If you invest for income correctly, then you will emphasize income investments that provide a stable, predictable and, even, growing income.
Instead of beating yourself up because your portfolio has not delivered any gains due to forces that are completely outside your control, the market has a mind of its own after all, a quick look at your income history will bring you enormous comfort.
Here are some examples of things I often find myself subconsciously saying to myself in times of market panic:
- “Wow, my income this year is X times greater than the year I started investing”.
- “I’m really stressed out about this investment that is down 20 percent but oh wait they just declared another dividend and it looks like they can continue paying it for the foreseeable future”.
- “This market is scary! Should I sell? but if I do I will stop receiving income from this investment and my annual income will go down”
- “This investment is down 20 percent, if I invest more now I will reduce my cost basis and get a higher yield, and I will substantially increase my income!”
Investing for income helps you stay sane in down markets and is even a source of motivation in periods of up or stable markets.
It is incredibly satisfying to see your dividend and interest come in like clockwork on a regular basis. You get a real sense of progress. That is the beauty of passive income after all, it keeps coming as you go about your normal life.
Place less focus on your total portfolio value and start putting more focus on the investment income generated by your portfolio.
2) Prepare for the future
Most long term investors invest because they want to be able to draw on their portfolios in the future, typically in retirement. As recommended by the financial independence and personal finance community, many do so by investing in broad equity and bond passive index funds over the long term.
While this is indeed a great approach with a great track record of success, I believe not enough thought is given to what you should do if/when you need to draw down on the portfolio. For example:
- What if your broad equity and bond portfolio does not deliver enough income in retirement or if an unforeseen event happens that makes you need income sooner rather than later?
- What if you don’t want to sell shares and use them to fund your living expenses?
- What if something happens to passive indexing or ETFs that make them unviable?
Life is unpredictable and so are the markets. I believe that it is better to educate yourself on income investing so that you are best prepared and able to navigate the ever changing world we live in.
I am big advocate of passive investing in general but I don’t think its prudent to limit yourself exclusively to broad equity and bond ETFs. It’s important to learn about all the different types of income investments and then choose whether you want to invest in them through passive or active strategies.
3) Control your income stream
One big advantage when you invest for income is that you can actually tailor your income stream to your specific needs.
To reach my goal of 1500 euros a month in investment income or 18,000 euros a year, this is what my portfolio size would need to be at various yield levels (excluding impact of taxes):
What a difference yield makes! Learning about getting as high a yield as possible, safely and consistently can accelerate your path to financial independence!
I emphasize safely and consistently because it becomes exponentially harder to meet this criteria at higher yield levels. There’s always a trade off when investing and high yield is usually due to high perceived risk!
When you invest for income you can control the investments that you make with the objective of reaching your target yield level with as much safety and stability as possible.
Of course, if your portfolio is so large or your income requirements so low, then even a low yielding portfolio of broad equity and bond ETFs will do (and will be incredibly easy to set up).
Generally, the more time you have before needing to draw on your income the less focus you should put on yield and the more focus you should put on growth.
If you invest for income, you can easily shift the balance in favour of extra yield over time by shifting your asset allocation into income investments with more yield.
Another big advantage when you invest for income is that you can control the stability to your income stream. If you look at the dividend history of broad market stock and bond ETFs or even dividend ETFs, you will notice that they fluctuate quite a lot.
When you invest for income, you can privilege dividend stocks, dividend growth stocks or Closed End Funds that have a long track record of maintaining and even increasing dividends over time.
You can also pick individual fixed income investments such as bonds or preferred shares that also consistently deliver a predictable income stream.
4) Get better value for money
Naturally as the prices of assets go up, the yield they will deliver will go down and the income stream will be less attractive to you.
For example, if a share of company XYZ is priced at 20 USD today and pays an annual dividend of 1 USD per share, then the yield you will get is 5%. If the price of the share doubles to 40 USD tomorrow, and you buy it then, you will still receive an annual dividend of 1 USD per share for a yield of 2.5%. Much less attractive!
When you’re looking at opportunities to invest for income, you will naturally stumble upon undervalued asset classes or more value-oriented investments because this where the yields will be most interesting.
There could be very good reasons why investments might be undervalued, and it could be because the company, sector or macroeconomic environment is facing challenges.
Most opportunities arise when there is excess fear in the market and it is at this point where it pays the most to invest for income, in assets that have unjustifiably been beaten down.
Warren Buffet springs to mind…
“Be fearful when others are greedy and greedy when others are fearful”, Warren Buffet
When you invest for income, it is much easier to follow Warren Buffet’s advice because you will be attracted to the yields and less scared of the market downtrend. You will also be able to use yield levels as buy signals for your investments. For example:
- when the corporate bond ETF currently trading at 3% yield will yield 4%, I will buy it.
- when this stock, which has a history of trading at an average of 2% yield over the last 10 years, reaches a yield of 3%, I will buy it.
Buying assets at good prices is easier when you invest for income and, guess what? That is also a great recipe for capital gains. Now that’s a win-win!
5) Take advantage of the tax code, or get comfortable with taxes
“Wait, what? Aren’t taxes one of the disadvantages of investing for income?” you may ask.
Yes, but please bear with me.
Wherever you are reading this from, your taxes will differ based on your location and individual circumstances. This is not a site about tax advice and you should do your own research regarding your tax impact before you invest for income.
Many countries provide a tax allowance (usually quite low) for dividend or interest income that can be earned tax free and I strongly suggest you take advantage of the tax code, if applicable, to invest for income and use it to learn about the many different types of income investments.
Tax optimization when investing is very important because taxes are definitely a significant burden on your portfolio growth and income stream.
Clearly, if there is a huge tax impact when you invest for income, then you need to minimize the income your portfolio generates while you focus on growth and tax-free reinvestment as much as possible.
The main message I want to pass here though, is that the tax burden should not be a reason to completely avoid income investments.
If there is absolutely no way for you to reduce the tax impact when you invest for income, then you should take the tax hit, consider it as a cost of education and keep your allocation to income investments small.
And to offer a bit of hope for those frustrated by investment taxes, you never know, the tax code might change for the best one day, so it pays to be ready to seize the moment if it comes!
And this wraps up the 5 most important reasons to invest for income, regardless of your personal situation. I hope you enjoyed this article, the first on this blog!