the basics of income investing

As an investment advisor, I’m constantly answering the question, “How do I cut through the clutter of bad investment strategies?” Everyone wants a strategy that makes them feel confident about investing in the future, especially in times of distress when everyone seems to be holding their breath.

Although there are many strategies investors believe in such as pure growth and value investing-with each having their own set of benefits and set-backs-my answer to this is a strategy that I preach to pretty much anyone who will listen, income investing. I even dedicated a whole chapter to it in my book, You Can Retire Sooner Than You Think.

Related: Warren Buffett’s Take On Value vs. Growth Investing

Let's get into what Income Investing is and why I believe it's the correct approach for long-term financial success.

What is income investing?

Income investing is a way to generate consistent cash flow from your liquid investments.

What this really means is that you are collecting the cash flow from dividends from stocks, interest from various types of bonds and distributions that come from a variety of investments (investments that pay distributions but don’t fit neatly in the stock or bond category). Adding the three of these together gives you a personal portfolio yield.

Income investing focuses on the production of a steady cash flow from the yield of your stocks, bonds and other investments, which can be reinvested in your portfolio or used to fund your spending needs if you need the cash flow.

Related: How The World Of Personal Investing Has Changed Over The Past 30 Years

This is different from pure growth investing in that pure growth investing relies on a rising stock market to build value. Income investing allows you to diversify your investments and collect a steady stream of income along the way. If this still seems confusing, let me explain this approach using a system I believe to be effective and easy to implement, if you take the time and energy to research and plan. I’ve named it the “bucket system.” (They’re buckets because you put your liquid net worth into them. Get it!?) All of the money you invest will fall into one of these four buckets and these groups work together towards your financial goals.

Cash Bucket – This bucket is your emergency fund; the money that lets you sleep well at night. To be safe, you should have about six months of living expenses stashed in money markets, CDs or savings.

Income Bucket – Contributions to this bucket are invested in various types of bonds — Treasury, corporate, municipal, high yield, TIPS, international, and floating rate. They will provide you with a steady interest income. A well-diversified bond portfolio should protect your principal, as well. To maximize your return over time you have to diversify within this bucket.

Growth Bucket – This bucket will hold different stocks for people in different stages in life. Younger investors who are still working typically invest in more growth-oriented stocks. These are shares in companies that have large growth rates, but usually they don’t pay much of a dividend. Their focus is on capital appreciation through growth in their revenue and earnings.
On the flip side, retirees typically focus more on dividend-paying stocks. These are companies that aim to give you some capital appreciation and pay you a nice dividend along the way.
Dividends accounted for 44 percent of the total return of the S&P 500 over the last 80 years. This is one reason I’m such a believer in income investing.

Alternative Bucket – This will be your smallest bucket. It holds investments that don’t fit neatly into either of the above buckets. For example, this bucket holds investments in energy royalty trusts (publicly traded oil and gas trusts), real estate investment trusts, preferred stocks, and MLP stocks (pipeline and energy storage companies). These are traded like normal stocks on the open exchanges, but they don’t pay traditional dividends or interest…they pay distributions. This type of investment is often considered riskier, hence why it is the smallest bucket.

The idea of using the bucket approach to income investing is that you can diversify your liquid savings and use them to either supplement your income in retirement or reinvest the portfolio’s income to accumulate more wealth over time.

All that being said, this is obviously not the only functional investment method in the world. However, I’ve found it to be effective for those who are looking for a low cost, transparent, and consistent investment strategy built for the long-run. Keep in mind it is important to check up on your bucket performance and make necessary adjustments as needed.

You can learn more about this method by reading my Wall Street Journal article on it here, or by picking up a copy of my book, You Can Retire Sooner Than You Think.

Related: TSL: How To Budget For Taxes, Savings & Life

Disclosure: This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.

Wes Moss, the Chief Investment Strategist for Wela, writes a weekly blog for AJC.com. You can find his original article here.

Editor’s Note: This post was originally published in July 2014 and has been completely updated for accuracy and comprehensiveness.