Investing For Income - 3 Methods

When it comes to investing for income on Wall Street, there are three general approaches adopted by income investors - investing in debt, investing in equity (dividends), and stock option income strategies.

Income investing is typically associated with retirees or older investors who, presumably, have spent a lifetime accumulating more growth-oriented investment assets such as stocks (usually in the form of index and managed mutual funds) but who now need to convert their "riskier" asset classes into "safer" cash flow vehicles to fund their retirement years.

Investing for Income - Investing in Debt

It's little wonder then that the dominant form of investing for income involves fixed income investing, or the purchase of some form of debt:

Government Debt - From U.S. Treasuries to state and local bonds, income investors have the option of purchasing individual issuances or going the ETF or fund route.
Corporate Debt - Categorized by credit quality, corporate debt is frequently traded on the open market by indidivual issuance, or can be purchased in the diversified form of an ETF or fund.
Preferred Stock - In spite of its name, preferred stock is actually a debt instrument, and junior to just about everything else except actual stock.

The appeal of these income vehicles is two-fold: for the most part these choices are considered to be safer than common stock while at the same time offering higher yields than common stock.

Those are the official conventional wisdom talking points, in any case. Reality often presents significant drawbacks not included in the flashy and breezy brochures.

And as with most instances of conventional wisdom, following mediocre advice will get you mediocre results.

In this case, investing for income primarily via debt instruments not only caps your income potential in retirement, it also leaves you at the mercy of interest rates. In periods of declining interest rates you risk seeing your income decrease, and in periods of rising inflation, you risk seeing your purchasing power decrease.

And to consider a corporate bond or preferred stock that will NEVER raise its payout to be high yield just because its payout may currently be twice that of its common share counterpart is to reveal a short-sighted mentality.

Investing for Income - Investing in Equity (Dividends)

Dividend growth investing, coupled with reinvesting those dividends, can produce copious amounts of wealth if approached realistically and intelligently.

The formula is relatively simple but does require discipline: regular infusions of new money invested in shares of the highest quality companies with growing earnings and growing dividends which are then reinvested in order to acquire even more shares.

But even more significant than the wealth that this style of investing can produce is something of great interest to the income investor - a significant and growing stream of dividend income.

It's important to note that it does take time for a dividend growth and reinvestment income stream to build into a gushing income river. And therein lies a danger for the income investor who has only begun investing for income at or near retirement.

Quite simply, the yields on high quality but dividend growing companies may be too low to produce the income necessary for those who need the money now.

Investing in a high quality company, for example, with a 2.5% current dividend yield and a 10-15% historical dividend growth rate may be a terrific long term investment.

But if it doesn't produce enough dividends for you in the here and now, and if you can't afford to reinvest those dividends in additional shares of this or some other quality dividend paying stock, then obviously it's an impractical investing option.

And this is where you have to be careful if you find yourself in this situation. It's the easiest thing in the world to be seduced by high yield dividend stocks and rationalize later that a low quality business or risky stock is actually a safe dividend investment.

Not all high yield stocks are high risk, of course, but even those that are structurally geared to payout the majority of its profits in the form of income (such as REITs and BDCs) may be far more cyclical and volatile than their advocates will freely admit.

Investing for Income - Stock Option Income

Although shunned by many conservative investors as too exotic or too risky, option income strategies such as covered call writing can be an effective income producing strategy.

Writing calls for income (and you can essentially do the same thing writing puts) can produce annualized returns far in excess of typical fixed income investments.

As with any form of trading (and this is trading, not investing) there are potential pitfalls. It usually comes down to how conservative or how aggressive you choose to be with your trades.

When it comes to options and risk, there are a couple of key points that really need to be spelled out.

First, it's important to recognize that options are ultimately about the trading and management of risk.

The bottom line is this: you can use options to outsource your risk (this is called hedging) at the cost of limiting your own profits, or you can use options to assume someone else's risk and, in the process, be rewarded with outsized gains (sometimes spectacularly so).

Second, and related to the above, and this is critical to understand: options are not a risk switch - they're a risk dial.

What that means is that you don't have to have the personality of a high stakes poker player to make money trading options.

Not all option trading strategies have to be high risk strategies. If you're willing to accept less compensation, you can afford to assume a lot less risk with your strategies.

In fact, I would argue that it's possible to be compensated for assuming volatility, not risk (and they are NOT the same).

So while I find option trading strategies like covered call writing, when approached conservatively, to be viable and safe, this page isn't about trading for income, it's about investing for income.

It's on this point that the Great Option Trading Strategies site is really like no other website.

This site respects traders and trading, but the primary reason this site even exists is to promote the radical idea that option trading can - and should be - be a crucial component of conservative long term investing.

What if, for example, you used options not as a way to try to win the lottery, not as a way to create some mega monthly cash flow machine, not as a high stakes replacement for real investing - what if instead you used options moderately and conservatively as a way to enhance your real investments?

This is the crux of what I call Leveraged Investing. The epiphany for me came when I realized that investments and option trading could actually work together, and that when they did so, it reduced the performance pressure, as it were, that each component faced when working in isolation.

Translation: Leveraged Investing can provide very good returns and still enable you to invest in high quality, low risk businesses.

More About Leveraged Investing

Leveraged Investing is how I personally invest and it's also how I'm teaching my young son to invest (and anyone else who will listen). I believe it's a fantastic way for younger investors to amass an incredible portfolio.

But because it attempts to, in effect, accelerate the results of a long term value investing approach, it could be worth serious consideration by older investors as well.

This style of investing may not be for everyone, of course.

Though not particularly difficult, it's not some kind of automated system or auto-trade monthly subscription service. It requires that you possess an actual interest in your own investments, a healthy curiosity about the investing process, and some common sense intelligence.

Sadly, not everyone possesses all three of these traits.

Finally, if you are considering options as a source of income, whether you're an investor going the Leveraged Investing route or a trader looking to use a covered call, iron condor, or some other credit spread subscription service, and regardless of your age or retirement horizon, you might also be interested in a couple of other pages on this site: The Myth of Monthly Cash Flow as well as The Hidden Risk of Option Income Trading.

Follow @LeveragedInvest