Introduction to income investing

Income investing is a strategy of building an investment portfolio to generate a regular stream of income. This differs from the objective of many portfolios, which is to grow your principal. While income investing and growth investing can work in harmony at times, they have different ultimate objectives. 

A clear benefit of income investing is the ability to create a steady stream of income from your investments. This strategy may be particularly beneficial for retirement planning: Your income investments can replace your earned income when you leave the workforce. 

Read more: Retirement income strategies: Get the most out of your retirement 

Though income investing is particularly beneficial during retirement, it can be used during any stage of an investor’s life. Many people choose to allocate a portion of their retirement account to income investing while still allocating another portion to growth investments. 

There’s not one correct way to build an income portfolio. You can choose from a variety of investment vehicles, including dividend-paying stocks, bonds, real estate investment trusts, money market funds, certificates of deposit (CDs), and more. 

The right income investment for you — or the right combination of multiple income investments — depends on personal factors such as your income goals, time horizon, and risk tolerance. 

Types of income investing 

If you’re planning to add income investing to your strategy, there are several ways you can go about it. You can choose just one of these approaches or, more likely, combine several of them together. 

Dividend-paying stocks 

Dividend stocks are among the most popular options for income investing. A dividend is a portion of a company’s profits that it pays to its shareholders. Though companies aren’t required to pay dividends, many choose to do so. Dividends are typically paid on a fixed schedule, meaning they can provide a regular source of income. 

Dividend-paying stocks have a dividend yield, which is the percentage of a company’s stock price that it pays in dividends. For example, suppose a company has a dividend yield of 5% and a stock price of $100 per share. Each year, you would earn $5 in dividends for each share you own. 

While dividends aren’t required, many companies use them to attract and reward investors. 

There are also companies that pride themselves on the longevity of their dividend payments. The title “dividend king” is one that’s awarded to companies that have paid dividends for more than 50 consecutive years, and it belongs to only a small portion of companies in the U.S. stock market.¹ This exclusive club includes well-known companies like Coca-Cola, Johnson & Johnson, Procter & Gamble, Walmart, and more. 

If you’re considering investing in dividend stocks as a source of income, it’s important to understand the risks. Like any other stock, these run the risk of declining stock prices. Additionally, because companies aren’t required to pay dividends, they could technically stop doing so or lower the dividend amount at any time. 

Read more: 10 varying risk investments for 2024 

Bonds 

A bond is another way to add income investing to your portfolio. A bond is a debt security, meaning the purchaser of the bond is lending the issuer of the bond money. The bond issuer makes regular interest payments to the bondholder, often twice per year. Then, once the bond reaches maturity, the issuer repays the full face value of the bond. 

For example, let’s say you purchase a $1,000 bond with a 5% interest rate. You would earn 5% of the bond’s face value per year — that’s $50 per year, often paid in two semi-annual payments of $25. If the bond has a 10-year term, you would earn a total of $500 in interest. And once those 10 years pass, you will get your $1,000 initial investment back. 

Thanks to their interest payments, bonds offer a predictable stream of income. The bond rate depends on several key factors, including the type of bond, the interest rate market when the bond was issued, and the credit rating of the bond issuer.  

For example, a bond from a company with a low credit rating will offer a higher yield than an investment-grade bond because of the increased risk to the bondholder. On the other hand, bonds issued by the U.S. Treasury often offer lower yields, but they are backed by the federal government, which reduces the risk of default. 

If you’re considering adding bonds to your portfolio as a way of income investing, you wouldn’t typically purchase just one bond or one type of bond. Instead, you would hold a diversified bond portfolio, either by choosing individual bonds from different issuers and maturing at different times or by investing in a bond fund. 

Real estate investment trusts

Real estate is one of the most popular forms of passive income. Unlike the other types of investing we’ll discuss, real estate has the potential to earn you a consistent income from owning a physical asset rather than holding a security like a stock or a bond. For this reason, real estate is often considered an alternative asset. 

There are multiple ways to add real estate to your income portfolio. First, you can own a residential or commercial rental property, which can yield monthly rental income. However, this type of real estate investing requires a lot of hands-on work, as well as costs associated with maintenance, property taxes, and more. Additionally, physical real estate holdings are quite illiquid, meaning it’s difficult to turn your asset into cash if needed. 

Read more: Investment strategies: Guide for beginners 

Alternatively, you could choose to invest in a real estate investment trust (REIT), which is a company that owns and operates real estate assets. Purchasing an REIT is similar to buying stock in any other publicly traded company, but it gives you some ownership of the company’s real estate holdings. 

REITs allow you to invest in and earn dividend income from the real estate investment trust without the upfront and ongoing costs associated with owning your own property but with the trade-off of lower potential returns. Many individual investors find REITs to be the best of both worlds: the benefits of investing in real estate without the responsibility of owning real estate. 

Money market funds 

A money market fund is a type of mutual fund that invests specifically in short-term debt securities. They invest in money market instruments like government and corporate debt securities. Money market funds are an attractive income investment option because of their low risk, which can also result in lower returns. 

Money market funds can serve an important role in an income investment portfolio.² First, they are highly liquid, meaning you can easily sell your holdings and turn them into cash. They also offer the opportunity to diversify your portfolio, mitigating some of the risk presented by other securities in your portfolio.  

Deposit accounts 

While traditional bank accounts aren’t an investment, they do offer a low-risk way to add some additional income into your portfolio, especially in today’s high-interest rate market. Deposit accounts like high-yield savings accounts and certificates of deposit (CDs) offer interest on the money held in your account. 

These accounts offer the unique benefit of being insured by the Federal Deposit Insurance Corporation (FDIC). If your bank goes out of business, your assets are insured by the Federal Deposit Insurance Corporation (FDIC) limits up to a certain amount.  Additionally, while interest rates are high, as they are in early 2024, these accounts may offer higher yields than some other investments. 

However, be mindful of holding too much cash: It’s often recommended to maintain only three- to six-months' worth of basic expenses in an emergency fund, plus cash for any short-term goals. 

Mutual funds and ETFs 

If diversification is important to you, mutual funds and exchange-traded funds (ETFs) can help you introduce income investing to your portfolio without having to pick and choose individual stocks and bonds. Mutual funds and ETFs are pooled investments, meaning they pool the money from many different investors and invest it in a variety of securities. 

Mutual funds and ETFs can come in many different forms. Some might invest in only stocks, while others invest in only bonds. Many also offer a combination of stocks and bonds. Many funds also offer exposure to a particular part of the market. For example, there are funds that invest in companies of specific market capitalizations or in specific sectors. 

Mutual funds and ETFs are either actively or passively managed. Actively-managed funds have managers who actively buy and sell securities in an effort to outperform the fund's benchmark index. Passively-managed funds, also known as index funds, track a particular market index, sector, or portion of the market. 

Mutual funds and ETFs have some key benefits. They make it easy to diversify your portfolio without buying many different investments. 

Mutual funds and ETFs can also be uniquely beneficial for income investing. There are funds specifically designed for income investors: These funds include dividend stock funds and bond funds. The funds you choose and how you choose to pair those with other assets in your portfolio depend on your overall financial goals, time horizon, risk tolerance, and more. 

Income investing pros and cons 

Income investing has both pros and cons, and it’s important to understand them before deciding to introduce this strategy to your portfolio. 

Pros of income investing 

• Regular source of income: First, income investments provide just that — income. Whether the income is in the form of dividends or interest, some of these investments allow you to create a new stream of income, whether during retirement or another life stage. 

• Opportunity for capital growth: In addition to generating income, these investments can also enjoy capital appreciation. For example, you could invest in a dividend stock that both pays regular dividends and increases in value while you own it. 

Cons of income investing 

• Income fluctuations: While income investments do provide income, it isn’t necessarily consistent in the amount. Dividend-paying companies could either decrease their dividend rate or get rid of dividends altogether. 

• Investing risk: In addition to the risk of declining income, income investments can also lose their value. Dividend stocks can see their prices decline, while bonds could lose some of their resale value if interest rates rise. 

Examples of income investing 

There are many different strategies you can choose when building your income investing portfolio. There’s no one-size-fits-all strategy, so it’s important for each investor to research their options and conider talking with a financial professional to determine what fits their needs. 

Here are a few examples of different approaches: 

Income-focused conservative strategy 

If you’re a more conservative investor or want guaranteed income, you may choose to take a more conservative approach to your portfolio. This might mean you build a portfolio of primarily government and investment-grade corporate bonds and include only a small portion of stocks. Most of your income comes from interest, but you also have the potential for some dividend income and capital appreciation. 

Income-focused balanced strategy 

Some with a moderate risk tolerance might prefer a balanced strategy. A more balanced income portfolio might include an equal or similar share of both stocks and bonds. You earn income from both dividends and interest while also having the potential for capital growth. 

Income-focused growth strategy 

Aggressive investors with high-risk tolerances might opt for a growth strategy. If you build a growth income portfolio, you will likely invest primarily in stocks. Most of your income will come from dividends, and you’ll have the potential for capital appreciation. Additionally, you’ll have some interest income from the portion of your portfolio invested in bonds. 

Diversification of income investing 

Whatever income investing strategy you choose, it’s critical that you prioritize diversification. There’s no one right way to build your portfolio. Some investors will prefer a stock-heavy portfolio, while others will opt for a higher percentage of bonds. Some might choose individual stocks and bonds, while others will invest in mutual funds and ETFs.  

No matter which strategy you choose, it’s important to diversify your portfolio at the very beginning and then revisit your asset allocation over time and rebalance as needed to ensure it still meets your needs. 

The bottom line 

Income investing can be a way to gain an additional stream of income, while also offering other benefits of investing, such as capital growth. Income investing is a popular strategy among retirees, but it can also be used during other life stages. Whether and when you introduce income investing to your portfolio is up to you. Consider consulting with a financial professional to analyze ways to incorporate different investing strategies into your financial portfolio.