I Want To Grow My Money...Why Would I Need Any Income Investments?

But I’m looking to grow my money. Why would I want income investments in my account?”

This is a common question I get from Wela clients as we talk through the process of developing a retirement savings portfolio to meet their particular objectives. It’s a great question that makes sense. And here’s the answer.

When we think about saving for retirement, we often visual our efforts as growing something -- a “nest egg” that expands with every deposit we make in our retirement account.

But a well-crafted retirement strategy is actually more like a machine than an incubator. It has several moving parts that work together to leverage your contributions and move you towards your goal. The twin motors in that machine are growth and income investments, which work together, with each taking the lead at different times in the journey to and through retirement.

Income investments

Income investments

Growth stocks are shares in companies that currently prioritize expansion and increased market share. These businesses pour most of their profits back into operations, and thus don’t pay dividends. Netflix and Amazon are good examples. If/as a growth company expands, investors benefit from the steady, sometimes dramatic, rise in value of their shares. Growth stocks are what people talk about at the office coffee machine. “Yeah, I bought Acme Corp at $10 a share five years ago and just sold it for $71.”

Income stocks are boring by comparison. They tend to be established companies in mature industries – think Proctor & Gamble, Apple, Disney – that are unlikely to show dramatic growth in share price. Instead they just ton the revenue and pay their shareholders a regular dividend.

Related: Income Investing - Cut Through The Clutter

Bonds, which are essentially a loan to a business or government, are another source of income, as owners of the bond receive regular interest payments. Investors can also receive income from alternative investments, including real estate investment trusts, preferred stocks and shares in pipeline and energy storage companies. All of these assets are traded on open markets like stocks and bonds.

So, let’s assemble Wela’s version of the retirement investment machine. It consists of three buckets based on the above – stocks, bonds and alternative investments – designed to grow your money while providing diversity to protect you from market volatility.

Stocks – During most of your working career, your portfolio should contain mostly shares in growth companies. Ideally, these stocks will significantly appreciate in value over the years and decades, providing a nice profit when you liquidate them in retirement.

But you should also hold some income stocks to provide diversification and stability. The dividends these shares pay can be reinvested in your portfolio, turbo-charging your growth.

Related: How To Build Your Investment Portfolio To Meet Your Retirement Needs

When you retire, we recommend shifting your focus to income stocks. You can continue to reinvest their dividend income, or use it to help fund your lifestyle. Income stocks also tend to be less volatile than growth shares and thus offer the stability you want in retirement.

Bonds – Contributions to this bucket are invested in a diversified range of bonds – Treasury municipal and corporate – that will provide a steady stream of interest income while protecting your principal.

Your portfolio should hold a greater percentage of bonds (as opposed to stocks), as you get closer to retirement. We recommend, “owning your age” in bonds. When you are in your 40’s, bonds should make up 40% of your portfolio. When you are 50, that percentage should be 50%.

Related: Why You Should "Own Your Age" In Your Investment Portfolio

Alternative investments – This smallest bucket of non-stock or bond assets provides more income and some insulation from the gyrations of the stock market.

So, why should you hold income investment when you’re seeking growth? Because income investments – stocks, bonds and alternative investments – can both enhance and protect that growth. The dividends, interest and other payments generated by income assets can be reinvested, even as those assets themselves insulate you from volatility by providing diversity and stability.

Your investment machine isn’t hitting on all cylinders unless you have income assets in the fuel mix.

Disclosure: The information is provided to you as a resource for educational purposes only. Nothing herein should be considered investment, legal, or tax advice. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results when considering any investment vehicle. This information 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. It 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.

How to Build your investment portfolio to meet your retirement needs

There are any number of core investment philosophies, each with it own merits and uses. How do you decide which strategy or philosophy works best for you?

At Wela, we believe both growth and income investing have important roles to play in a successful retirement portfolio. During the front part of your wealth-building years, we recommend a growth strategy in which you invest heavily in stocks that will gain in value over the years (and decades), allowing you to reap significant profits when you cash out.

But as you near retirement we believe in transitioning to an income-driven portfolio consisting largely of assets that generate a steady cash flow that can provide you with a “paycheck” in retirement. That income comes from stock dividends, bond interest and income from alternative investments, such as preferred stocks, real estate investment trusts (REITS) and royalties from energy trusts.

One thing I love about income investing is that a well-crafted income portfolio can meet your retirement spending needs for years while limiting the drain on your capital.

 

Working Years: To understand the benefit of income investing, it might help to think of your retirement portfolio as a house. During your working years, you build your portfolio brick-by-brick -- dollar-by-dollar, asset-by-asset. It begins as a starter home -- functional but not fancy. Over time, you add rooms and amenities; a second floor, basement media room and a deck. With luck, the house appreciates over the decades until it’s worth, say, a million dollars.

Retirement: Now it’s time to retire. How do you get your money out of the house? Well, if it’s a growth “house,” you sell it off piece-by-piece and use the proceeds to fund your retirement. When the last piece is sold, the money is gone.

But if it’s an income house, it generates “rent” in the form of that asset income from stocks, bonds and other investments. That income, previously reinvested while you were “building the house” can now be used to cover your expenses. You may well have to sell some parts of the house over the years, but at a slower rate than the owner of a growth “house.”

How much slower? Well, imagine you have a portfolio at retirement worth $500,000 that can generate $20,000 in annual income. Assuming you can live on that money (plus Social Security, pensions, et cetera) after 10 years you would have derived $200,000 from your portfolio but it would still be worth about $500,000, depending on how the market moves.

In order to derive the benefits of both growth and income investing, we recommend the “bucket” approach to creating an effective retirement investment portfolio. As the name suggests, your investments will fall into one of three categories or “buckets.”

Bonds – Contributions to this bucket are invested in a diversified range of bonds – Treasury municipal and corporate – that will provide a steady stream of interest income while protecting your principal. To maximize your return over time you will need to diversify these holdings.

Your portfolio should hold a greater percentage of bonds (as opposed to stocks), as you get closer to retirement. We recommend “owning your age” in bonds. When you are in your 30’s, bonds should make up 30% of your portfolio. When you are 50, that percentage should be 50%.

Stocks – This is where growth comes into play. During your working career this bucket will contain mostly shares in companies that have large growth rates, but don’t pay much of a dividend. Think Netflix or Amazon. Ideally, these stocks will significantly appreciate in value over the years. When you retire, you will shift your holdings into income stocks – shares that show some growth but pay a nice dividend. Apple and Disney are good examples. There are several excellent growth ETFs that allow you to tap into the appreciation of a whole basket of companies.

Alternative Income – This smallest bucket holds income-generating assets that are neither stocks nor bonds. This includes real estate investment trusts, preferred stocks and shares in pipeline and energy storage companies. All of these assets are traded on open markets like stocks and bonds.

While income investing isn’t the only way to saving for the future, in our experience it’s a way to have your “house” provide safety and warmth during your retirement years.

Interested in learning more about investing? Read how an average family retired with 1 million dollars in savings. Download our free eBook on investing here

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. 

I Liked PE In School, But Don't Understand It Now That I'm Investing. What Is The Price To Earnings Ratio?

Let’s talk for a minute about a key measure of stock value, the Price to Earnings Ratio or P/E.

Yes, yes – you were told there would be no complicated formulae, rituals or incantations involved in growing your nest egg. But the P/E isn’t all that complicated and it’s a pretty handy tool for assessing possible investments, and for impressing people at the bar when the conversation turns from sports to the hot stock du jour.

The P/E is simply the ratio of a stock’s current selling price to the company’s recent earnings per share (EPS), typically over the past four quarters. If Acme Industries shares are currently trading at $30 and its EPS is $2, the P/E would be how much? Come on, you know this. Right. 15.

The P/E can help determine whether a stock you are considering is “expensive” or “cheap.” When you invest, you want to buy into companies that have strong earnings, or the near-term prospect of strong earnings. And, ideally, you want to pay as little as possible for those earnings. In the Acme example above, you are paying $15 for every dollar of earnings that you buy.

Related: 7 Ways To Get Started Investing

Whether a P/E is “good” or “bad” depends on several factors, including the company’s growth rates – past, present and expected. A stock’s P/E reflects the market’s level of confidence in the company. A P/E above the market or industry average is a sign that the market is expecting significant success and earnings growth from the company in the near term.

But the P/E isn’t perfect and should not be the sole measure of a possible investment. For example, beware of a stock with a high P/E despite low recent growth. Something isn’t right in that situation. The stock may, for example, be benefitting from unjustified media hype or Wall Street buzz. Similarly, a stock might be considered over-priced if its current P/E isn’t supported by analysts’ projections for the company’s future growth.

Related: Just The Basics: 9 Common Ways To Invest

Industry norms must also be weighed when assessing a P/E. You can’t really compare the P/E of two companies in different categories; such as a utility and a start-up tech firm. The P/E ranges for those industries are wildly different. Utilities are stable, low-growth operations and tech firms experience wild growth and constant upheaval.

There, that wasn’t too painful, was it? And now you’ve got another tool to help make smart investment decision – or to at least better understand the decisions you’ve entrusted to your financial advisor.

Does A Quiet Market Spell Trouble?

The VIX, a trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index, is a measure of implied volatility in the market over the next 30 days. Also known as the fear gauge, it represents how people perceive the current markets' risk. On June 6, the VIX actually went to a recent low of under 11, which is the lowest the VIX has been since February 2007, and close to the lowest level in its history. We all remember what happened in 2007 with the housing market bubble burst and ensuing stock market plummet, when the VIX reached 85 during the peak of the crisis. So what does it mean now that the VIX looks as low now as it did then?

There’s currently a camp that is very nervous about this. They’re saying that this low VIX is a clear signal of investor “complacency” with the stock market, which means we could be in for a world of trouble.

However, just because the perceived volatility is low does not mean that the market has to crash. Back in October and November of 2013 the VIX was under 14 (again a very low number) for 32 consecutive days. Then the S&P gained almost 2.5 percent through the end of the year.

Markets don’t crash because of a low VIX. They crash for reasons that make the VIX high, and reasons that create volatility -- like fear.

Fear of war (think today’s turmoil in Iraq and Ukraine), terrorism, market bubbles popping, great recessions and the like, can all cause the VIX to rise.

I believe that today’s “complacency” isn’t a forgetful one. Investors I talk to aren’t saying, “Let’s own stocks because they are guaranteed to go up. We have no risk of losing money.” Most investors have been around long enough now to have experienced or at least know about several bear markets, and understand that the stock market cannot always promise you a positive return in the near term.

I think that investors are less complacent and more confounded.

Currently the stock market looks fairly valued, not cheap, but also not overpriced. Bonds currently have some merit due to their protective nature coupled with their ability to provide consistent cash flow. Furthermore, the US economy looks slightly better than lukewarm – but still shy of being overheated.

Perhaps we have all been on edge so long about the stock market crashing again that we don’t know how to be comfortable with a low volatility market.

Don’t just take my word for it. HSBC strategist Garry Evans was quoted in Barron’s saying, “In fact, low volatility is typically a characteristic of the “stable phase” of bull markets. At the very least, we can say that never in the 25-year history of the VIX did a bear market appear when volatility was low.”

Bottom line

This low VIX isn’t a necessarily a bad thing. All of this gives me the impression that investors feel comfortable enough not to sell; but not comfortable enough to bid up the price (buy more) of their existing holdings.

In my new book, You Can Retire Sooner Than You Think, I offer a solution for investors who are “confounded” as to what to do with their 401k and retirement savings. I also discuss how to come to terms with stock market and economy’s perpetual gyrations. Chapter 8 is dedicated to a strategy known as income investing – as well as a diversification approach I’ve coined the “bucket system”.

Would you like more tips on retiring sooner? Take my free money and happiness quiz on the right hand side of wesmoss.com.

 

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