Income investing comes with both risks and rewards, just like all investments.
The risks of income investing in bonds includes interest rate risk, default risk, inflation risk and more. And for stock income investors, there is bear market risk and political risk. Both bond and stock income investors face company or entity specific risk and economic risk.
In this post, I’ll address the risks of income investing focusing on stocks and bonds. We like including more alternative investments for higher yields, potential tax benefits and less risk through increased diversification, but since stocks and bonds are the two most common income investments I’ll focus on them.
While I hold an AFC® credential, I write mostly from my own experience after almost 40 years of investing alone, in funds, and also with several financial advisors.
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What Is Income Investing?
Income investing is when you invest with the primary goal of making income from your investments. This is contrary to growth investing where the main goal is for an investment to increase in value. This growth is often called capital gains in financial lingo.
Income investing is also thought of as slightly less risky than growth investing since most income investments continue to pay income, even if the price of the investment (stock or bond) declines.
Most investors think of bonds when it comes to income investing but there are other “slightly” alternative income investments.
This is because bonds are used most often to offset stock market risk in investment portfolios in standard asset allocation models used by both individual investors and wealth managers.
Because I focus on lower risk investing given my age, I just want to first mention this: Before investing in anything it’s important to have an overall wealth plan that defines your investment goals and acceptable risk to your portfolio based on your age and other factors.
Bonds as Income Investments
Bonds are the most common income investment. There are many different kinds of bonds all with varying levels of income and risk.
The prevailing interest rate, quality of the issuing company or entity and the duration (number of years) of the bond determines how much income a bond pays to their bond holders.
And these factors all affect the risk of investing in bonds. Riskier high yield bonds pay more income than U. S. Treasury bonds. And long term bonds pay more income than shorter term bonds, for example.
Intermediate 10 year Treasury notes as of this writing pay only about 2% interest. For comparison purposes, this is similar to an S%P 500 stock index fund.
Evaluating Bonds By Yield Comparisons
Comparing the yield (income) difference among the various types of bonds is often done as a way to evaluate bonds, as well as to evaluate overall investment risk from economic problems.
Investors can use this information to decrease the risk of income investing.
For example, short term bonds, at times, will occasionally pay as much as long term bonds, yet, logically long term bonds are riskier since an investor’s money is tied up longer.
Note that when short term bond yields are higher than long term bond yields it’s called in inverted yield curve. An inverted yield curve is a well known predictor of recessions and related bear markets, which spell risk for almost all investors.
An inverted yield curve is an anomaly, and it’s something smart income investors notice so they can be proactive during times of higher risk. Riskier companies issue “junk” bonds with a higher yield due to their higher risk. But sometimes the yield of junk bonds and higher quality Treasury bonds narrows, for example.
Comparing the yield between different types of bonds can offer simple insights for income investors that can guide them to higher yields with lower risk.
I am writing a post with the different risks of bond investing which will be up next week.
Income Investing Risks with Alternative Assets
There has been a major transition from using only bonds for income investing to other ways to invest for income as more products that were previously only available to high net worth investors and institutions have become available to almost all individual investors.
While bonds continue to be the only income investment many investors use, MLPs and REITs have become more common alternative income investments.
Plus, stock dividends, closed end funds, and ETFs all offer income opportunities for those looking to live off investments.
Nowadays, real estate rentals, small business lending and real estate lending are increasing in popularity as income investors seek ways to increase yield.
Many of these new income investment opportunities for individual investors are a result of the internet. But I’ll focus mostly on stocks, and bonds to a lesser extent in this post since these are the income investments that most investors own at least in a core investment portfolio.
Please read my other posts about alternative income investments including online businesses.
Factors That Increase the Risks of Income Investing
Here are the 7 factors that increase income investing risks in general.
These risks relate mostly to both stock and bond income investing but most also relate to investing in alternative income investments.
1. Income Investing Risk from Not Having Enough Savings
It seems to me that the biggest risk today for income investing is not having enough money to produce enough income given low yields from traditional investments in stocks and bonds.
It’s scary how much savings you need to generate $5,000 a month in income, for example. To demonstrate the importance of this serious income investing risk, let’s look at some numbers.
How Much You Need in Savings to Make $5,000 a Month
To see how much you need in savings to make $5,000 in monthly income, or any other amount, just multiply the monthly income by 12, and divide the annual amount by the expected yield.
For example, $5,000 income a month is $60,000 income annually. You’ll need to invest $2,000,000 to make $5,000 a month in investment income with an expected yield of 3%.
This means that your net worth will need to be much higher than $2,000,000 since you’d also have money in your home and other investments.
There are two important things to note about how much you need to invest to generate a certain amount of income.
Monthly Income Varies
Note that most income investments, such as dividend stocks, pay income quarterly. Income of $5,000 a month is based on an annual average.
Taxes and Fees
For simplicity, we’ll ignore taxes and fees in this required investment income equation but I can almost promise you they will eat some of your investment income somewhere, somehow.
For this reason, it’s important to plan for these expenses in your personal wealth plan.
Click here to read my post How Much Money Do You Need to Retire where I address handling extraordinary expenses like taxes.
2. Low Yield Is A Risk for Income Investors
We just looked at risk from not having enough savings to generate investment income.
The other side of this equation is yield. Low stock and bond yields are a major risk for income investors because they simply don’t generate enough income to live for most investors and retirees.
As I write, a yield of 3% used in the example is a reasonable yield for an investment portfolio of stocks and intermediate Treasury bonds with a focus on income generation.
It’s easy to see that the investment yield is really important here. And the amount of savings needed to live off investments is huge given the low stock dividends and bond yields.
Plus, many investors don’t realize how low investment income is because they confuse long term compounded returns with income as covered more later in this post.
3. Income Investing Risk from Inflation
Inflation decreases the value of your money most years. Historically, inflation is about 3% a year. More recently, inflation has reportedly been 2%.
This leaves a 1% real yield when we apply a 2% inflation rate to the common 3% yield in our example. This makes inflation a huge risk for income investors, but only for investors who don’t factor it into their investments and estimated spending in retirement.
Inflation is a particularly nasty risk for income investors because you don’t see it.
I don’t know about you, but for me, if its out of sight it’s often out of mind. But probably like you, too, I am reminded of inflation every time I go to the grocery store.
Ways to Reduce Inflation Risk for Income Investors
Buying TIPS bonds is one common investment to protect against inflation.
It is not an inflation protection strategy I use now for several reasons. (I tend to write only about investments I have personally made.) Hedging is a common strategy to lower the risk of income investing.
While hedging sounds complicated, it means that one investment maintains or increases in value (or purchasing power) while another investment decreases in value (or purchasing power).
Note that the value of some investments, and also the income they generate, will rise with inflation. This is what I mean when I say the investment income purchasing power is maintained.
Real estate rentals is a good example. The value of the property increases and rent increases as inflation increases.
This means the purchasing power of the income from our real estate rentals is maintained due to the rental increases. That is one aspect of investing in real estate rentals that I love.
4. Risk from Income Investments Period
Income investing in inherently risky because every investment has risks. But then you can’t generate investment income (or grow your wealth) unless you invest.
The reality is that when you invest in anything, there is a good probability that the value of that investment will decrease in value, often significantly. For stock income investors, this is especially true after years of bull markets when investments feel less risky.
This leads investors to feel overly confident in investing when they should be most cautious. And as covered earlier, bonds have different types of risk, too.
So to reduce income investing risk, you’ll first want to decide how much risk you want to take and then invest within that decision to keep your money safe.
This all goes back to your overall wealth plan.
Risk from Income Stocks
Many investors over estimate the safety of income investments. By doing so, they are increasing their risk through unawareness.
I silently cringe when I hear statements like “I am invested in conservative income stocks so I don’t have much risk in my portfolio.” Based on history, stocks will drop by roughly 30% to 55% during bear markets once or twice a decade.
While income stocks usually drop less, they will still drop significantly if history repeats itself. And while U.S. Treasuries usually counter stock risk, bonds have risk too as covered earlier.
The reality is that the asset you’re using to generate income is almost always subject to declining substantially in value.
Fortunately, there is reliable and historical data that can guide investors to lessen the risk of income investing. And investors can always choose to not sell at a loss (wait out the declines).
In this case, they won’t have a realized loss but this leads to a drop in net worth, at least until their investments likely and eventually rise in value again.
5. Risk from Misunderstanding Income Investment Returns
As mentioned earlier, many investors confuse generating investment income with capital gains and investment returns.
Let me explain so this is clear because it is a huge risk of income investing since it leads investors to over estimate the amount of income they will get. I get comments on my YouTube channel from investors who are downright angry when I explain that income from the S&P 500 index is around 2%.
They argue that the annual return from the S&P 500 is 10%. Not understanding the difference between investment income and investment return can lead to huge risk, especially for someone planning to live off investments in retirement.
A. Investment Income
Investment income comes from the payouts you get while you own investments, such as bond interest, stock dividends, real estate rent, covered call income, and MLP and REIT distributions, for example.
B. Capital Gains
On the other hand, capital gains occur when an investment goes up in value after you buy it. If you buy an investment for $10,000 and it increases to $11,000 you have a capital gain of $1,000.
This is called growth, as I referred to earlier in this post. If you actually sell the investment and take the profits, it’s called a realized gain.
In this case, the money from this gain goes right into your investment account. (And if you don’t sell the investment, it is an unrealized gain, so you just see the value of your account change. This increases your net worth.)
Click here to read my post How Much Money Do You Need to Live Off Investments where I explain this more.
C. Investment Returns
Besides investment income and capital gains, the term “investment return” is commonly used when talking about how well an investment has done.
Investment returns generally include both the amount an investment increases in value plus dividend payouts plus any compounding.
GAINS + DIVIDENDS + COMPOUNDING = INVESTMENT RETURN
A common investment return that you often hear quoted (and often misunderstood) is for the S&P 500 index, for example. Over many decades, this annual return average is around 10%.
Click the video to see more about the risks of income investing and this common misconception.
That 10% return number includes capital gains and dividends reinvested, all compounded over time. This means you cannot plan to live off investment income of 10% from stocks.
You may be able to live off capital gains in the years they occur, but it’s better to let those gains compound, at least in your younger years. This is addressed next as it relates to income investing risk.
6. The Risk of Selling Income Investments at Losses
Income investments often decrease in value instead of increase in value as anticipated. This presents risk for investors who have to sell investments at a loss during bear markets.
The way to avoid this risk is to have some investments that move up when others decline in value.
Another way to avoid this risk is to have enough cash to pay expenses during market declines, to have hedged liquid investments, or to have enough income generating investments to cover all your living expenses.
7. Lack of Information on Alternative Income Investments
While the focus of this post has been mostly on stocks and bonds, it’s important to note that some of the alternative income investments mentioned above have special risks.
More options for income investing is good for investors because most of these investments, such as closed end funds and online funding have higher yields than bonds and even dividend stocks. But there is often less information on some of these alternative income investments which increases risks.
Also, some alternative income investments, such as online lending platforms and crowd funding, lack historical data and testing because they are so new. This increase risks from these specific income investing methods.
I like alternative income investments but it’s important to research any investment you make. With less information or history available, there is a higher risk with any investment.
Income Investing Can Lower Risk
Since income investments usually continue to pay income during bear markets, they drop less than growth stocks.
Not only this, but income investments can allow many investors to live off investment income rather than taking traditional retirement income withdrawals.
Risks of Income Investing Summary
As you read in this post, income investing can increase investment risk but it can also lower investment risk. And the risks of income investing are lower with diversification among many different types of investments.
This can include alternative investments such as real estate rentals and small business.
With all investing, it’s important to begin with a wealth plan that clarifies how much risk you want to take and choose investments from that clarification to meet your goals.
The best place to start is with my Ultimate Wealth Plan. You can get it here now.
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