In our articles on investing we often stress the importance of having a clear investment strategy. This is essential to a successful portfolio for two reasons (among many). First, it instills a sense of long-term thinking, helping to keep down unproductive moves like emotional trading.

Second, it helps to guide how an investor purchases their assets. Keeping a clear strategy in mind will help you choose investments that are compatible over the long run rather than a scattershot of individual products that each sound good on paper, but which might add up to less than the sum of their parts.

Income investing is one such strategy. It's one of the major strategies that financial advisers guide retail investors toward, along with approaches such as risk mitigation and aggressive growth. Done right, it can help you build a vibrant, fast-growing nest egg or even supplement your household earnings.

What Is Income Investing?

Income investing is when you build a portfolio to maximize annual earnings. Typically the way to do this is by focusing on assets which generate regular payments such as dividends, interest, capital gains from a fund and the like. This creates what is known as a passive income stream (earnings that come from owning certain assets).

For example, say you built a portfolio out of shares in ABC Corp. and bonds issued by XYZ Incorporated. Your investment in ABC Corp. pays a $1,000 in dividends every six months, and your XYZ Incorporated bonds issue $250 in coupon payments quarterly. Together they would generate $3,000 of income every year. This is passive income because it's income you earned simply from owning these assets rather than selling them. The portfolio is an example of income investing because you bought these assets based on their annual earnings.

An income investing approach is about maximizing annual returns. Most investors measure this by earnings per year and build their portfolios to try and earn as much in total annual payments as possible. You do this by collecting assets which maximize your annual rate of return while also maintaining an acceptable level of risk in your portfolio. (This is important because many of the more profitable assets, especially among bonds and funds, are also the riskiest.)

Income Investing - Specific Definitions

Readers should note that this is an area where professionals use their terminology differently.

Some investors use the term "income investing" to refer to any kind of portfolio strategy designed to generate an annual return. That can include not only collecting the earnings generated through passive income but also a strategy built around buying and selling assets on a regular basis throughout the year. Under this definition, any portfolio management strategy designed to produce an annual rate of return is considered income investing.

This approach can also be known as active investing or speculation.

Other investors use the term "income investing" to refer specifically to an approach which emphasizes passive income. This form of income investing involves selecting assets based on their maximum rate of annual payments, and is designed around a passive strategy of buying and holding assets (often for multiple years). Under this definition, a portfolio management strategy is considered income investing when it generates its return through payments made by the assets rather than by selling those assets for a profit.

For the purposes of this article, we will use the second, passive, definition of income investing.

Forms of Income

There are many ways you can include income-generating assets in your portfolio. The most common include:

  • Stock Dividends - Many companies will periodically return a portion of corporate profits to shareholders in the form of stock dividends.
  • Bond Interest - These are the interest payments that companies make throughout the year on corporate bonds that they issue. Note that U.S. Treasury Bonds do not pay regular interest.
  • Fund Payments - Many mutual funds will issue payments to shareholders when the fund sells assets at a profit.
  • Contract Payments - Many forms of securities involve regular payments, such as with an annuity, some forms of life insurance or a certificate of deposit.
  • Banking Interest - A savings account will generate regular interest, deposited directly into your account. This, too, is an income investment… albeit a rather poor one.
  • Real Property - While beyond the scope of this article, any real property which generates income (such as rental units or vacation homes) can be considered an income investment.

While this is by no means an exhaustive list, any of these products will generate income off of your money over time.

Why Invest for Income?

While there are many things you can do with income investing, most investors choose one of two approaches:

Rollover Investments

Many income investors use their earnings to grow their portfolio. This is a particularly common approach for investors focused on long term goals, such as growing a retirement fund or savings money for college.

With a rollover approach, investors reinvest the income their portfolio generates. This can mean buying more of the assets that they already hold, or it can mean diversifying by purchasing new assets. Regardless, the investor takes their money and puts it back into their portfolio. This means that they will hold more income generating assets in the coming year, providing a larger stream of income with which to buy still more assets.

Done right, this allows the income investor to take advantage of compound growth year after year, growing their portfolio then using that growth to do so again.

Household Income

Other income investors use their portfolio as a source of supplemental income. In rare cases they use their income investments as a source of all of their household's income, living entirely off the profits that their portfolio generates. This is common for people who have substantial fortunes. (For example, say you won $10 million in the lottery. If you put every penny of that into bonds with a 5% annual rate of return, you could generate half a million dollars per year of income. That's a very nice living without having to spend the fortune at the center of it.)

A household income approach is most common for investors who feel that they have met their financial goals. They don't need to continue growing their portfolio for it to meet the benchmarks they've set out. As a result, the investor can keep the money their portfolio generates.

This strategy is not recommended for all, or even most, investors. For example, it will often not produce strong results for investors still growing certain aspects of their portfolio, such as a retirement account, or who could face financial troubles if their portfolio lost significant value. In both cases, you could use the income from your portfolio to shore up the areas where you've not yet met your financial goals.

Household Income: Retirement

It is not uncommon for retirees to use income investing as a way to supplement their household income. Unlike many household income approaches, this is a potentially excellent use of income investing. If you have met your retirement goals, and feel that your money is secure for your retirement, there's nothing wrong with spending the money generated by a portfolio. After all, you can't take it with you..