The Four Principles of Income Investing

I’m a huge fan of the magic of dividend growth investing. DGI uses the power of compounding to create massive income and capital gains in the future.

However, as much as I love DGI, I prefer the magic of income investing. Income investors seek current income that produces cash today—not tomorrow.

When you purchase one of the six income-investing products, you know how much it will pay you. If you can buy it at a discount, you can increase your yield even further.

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The four principles of income investing. Over my five years of income investing, I have lived by a few principles. These principles help me create massive income that I can use today, tomorrow, or someday in the future.

The four principles of income investing are shopping on discount, targeted reinvestment, rule of 72, and automatic investing. Let’s examine these in detail.

Shopping on discount. The rule of income investing is to shop at a discount. Most income-investing products are considered fixed income.

Fixed income means that the product pays a set amount of income. For example, a $25 preferred share may pay $1 in annual dividends, giving it a 4% yield at par value.

However, if you bought the same preferred share for $20, you would get a yield on cost of 5%. If you bought it for $16, the yield on cost would be 6.25%.

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The goal of income investing is to find strong income products that the market has mispriced. It’s like going shopping on Black Friday.

Income investors always have a list of products they are ready to pounce on. We can grab huge income at tiny prices if the market makes mistakes.

This means income comes first and capital gains second. We can get forced capital gains by purchasing discounted shares and waiting for the price to recover.

Targeted reinvestment. The second principle of income investing is targeted reinvestment. As you begin your journey, income will flow into your brokerage accounts.

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Dividend growth investors reinvest their dividends back into their original companies, while income investors prefer to take dividends as cash.

This gives us cash on hand to find and purchase discounted shares. For example, I bought Exxon Mobil (XOM) shares when its yield was 8%. The price has increased today, and the yield is close to 3%.

I take these dividends and invest in mispriced preferred shares and closed-end funds. The goal is to use your income to create more income. We are not in love with companies; we are in love with income.

We always want to reinvest at least 25% of our dividends into our portfolio. This habit guarantees that our income will outpace inflation.

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Rule of 72. The third principle of income investing is the rule of 72. The rule of 72 states that dividing 72 by the yield will tell you how long it takes to get your initial investment back.

For example, let’s say we have a 9% yield on the PIMCO Dynamic Fund (PDI). If I divide 72 by 9, it will take eight years to get my money back from dividends.

Income investors are very keen on tracking their income and returns. For example, let’s say you hold a preferred share for ten years.

You paid $16 for it and collected $16 in dividends over the years. The company then “called” the preferred and paid you the par value of $25.

This means you collected $24 in income for a $16 investment—a 150% return. At any point, I can tell you how much income I have received from my income-investing products. 

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Income investing is a math game; tracking your income is part of the program. We don’t depend on the companies to make us wealthy; our income will.

Automatic investing. The final principle of income investing is automatic investing. As investors, we must pump money into our accounts automatically.

This is fresh money, beyond reinvesting dividends. The most crucial part is transferring money into your income-investing portfolio.

Even if it sits in your cash pile or money market fund as “dry powder,” it’s vital that you keep adding money to your account. 

I currently earn $2,000 per month just from dividends; however, my goal is to push at least $1,500 more into these accounts from my household budget.

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Automatic investing ensures I am budgeting for my income portfolio in real life. As long as I add fresh cash flow and reinvest 25% of my dividends, I will easily trump inflation.

Putting it all together. Income investing is all about math, while dividend growth investing is about picking good companies and consistently increasing your position.

With income investing, there is always a new preferred share, bond, or real estate investment trust to purchase. We may have minor or significant positions in these companies. 

Income investing requires extensive reading. You must understand treasury yields, bond prices, the housing market, and lending practices.

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Fixed income is all about interest rates; therefore, that is the primary focus of income investors. Where are interest rates going? How is bank lending? Are people defaulting? What are the spreads of various products versus Treasury Bonds?

Dividend growth investors can follow their respective companies, while income investors follow the boarder market. This is because a lot of the income for income investors comes from the bond markets.

Current income vs. future income. The main difference between income investing and dividend growth is the timing of income. When I purchase AGNC Mortgage REIT (AGNC), I will buy it for the 14% yield on cost today.

When I purchase the 3% yielding McDonald’s today, I hope it will increase its dividend payment and stock price over the next 30 years.

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Eventually, the yield on cost for McDonald’s may reach 30% to 40%, based on rising dividends. In a perfect world, in 30 years, I turn off dividend reinvestment on MCD and live off the income.

Conclusion. If you love math and money, income investing is for you. When I have $1,000 to invest, I love knowing it will generate $100 of annual income with an investment in a 10%-yielding closed-end fund.

The magic of income investing is knowing the power of fixed income. You don’t rely on your company to increase its payouts or share price; you get exactly what you need upon purchase.

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However, you may also be surprised by dividend raises, special dividends, and supplemental dividends. With income investing, the majority of your returns will come from distributions, not capital gains.

I love being an income investor. Nothing warms my heart more than receiving dividends in the morning. I love using fresh income and dividends to purchase even more income—it’s become an obsession, really.

If you love cash in hand, income investing may be your right path. Follow the four principles and make good decisions. Don’t chase yield; chase good deals that produce good income. Good Luck!

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