Income Investing: Invest Using the Rule of 72

I heart income investing. I love having the ability to convert fresh cash flow into permanent passive income. However, income investing is not for everyone.

From the outside looking in, income investing may seem like a risky endeavor. Typically, yields are much higher than those of index funds and dividend growth investing.

When people see high yields, they may assume that the stock or fund is in trouble, and it may be. However, once you understand the underlying products, you’ll begin to build much more confidence in your strategy.

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I invest using the rule of 72. The rule tells me how long it will take to get my initial money back. The higher the yield, the faster my initial money returns.

What is the rule of 72? The rule of 72 states you can divide 72 by the yield to see how long it will take for your money to double. Let’s run a couple of examples.

Let’s say I had a $25 preferred share that yields 5%. It would take me 14.4 years (72 ÷ 5) for me to reach $50 from this investment.

However, you should always use total return as your yield requirement. For example, let’s look at McDonald’s (MCD). Let’s say it pays a 3% dividend and grows at a rate of 7% per year. If I invested $100, it would take 7.2 years (72/10) for this investment to grow to $200.

I use a different metric for income investing. I don’t assume any capital appreciation in the stocks I pick. I basically do a rough analysis of the product using the rule of 72.

Preferred Shares vs. Treasury Bonds

For example, assume AGNC Mortgage REIT (AGNC) yields 14%. I assume I will get my money back in 5.14 years (72/14). However, I know that this is not the case.

I won’t get my money back in five years because I do not automatically reinvest my money back into AGNC. I receive the dividends and then pick the most enticing stocks at the time.

The rule of 72 assumes that you keep the money inside the investment to maximize the power of compounding. Therefore, I use the rule as a basic metric to predict the velocity of money.

What is the velocity of money? Every investor should care deeply about the velocity of money. The velocity of money tells you how fast you get your initial money back from an investment and into another project.

The velocity of money is why I strongly prefer income investing over dividend growth investing and index funds.

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Let’s invest $1,000 into three different products, for a total of $3,000. The money will go into Eagle Point Credit (ECC) at 20%, Johnson & Johnson (JNJ) at 3%, and the Nasdaq Index fund (QQQ) at 0.4%.

My ECC position would pay me $200 per year that I could use to purchase JNJ and QQQ. My velocity of money would be incredible because I am reinvesting and lowering my overall risk.

Johnson & Johnson’s share price may appreciate in value, but it will only pay $30 in annual dividends. It will be challenging to diversify my investments with $30.

The dividends from QQQ are not even worth discussing, as it’s better to reinvest them back into QQQ.

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Overall, QQQ’s position would have probably grown the most, followed by JNJ. However, how do you tap into that capital appreciation?

Never sell shares to generate income. Most income investors do not sell shares to generate income; they use dividends to fund their lifestyle. I wholeheartedly agree with this philosophy.

I never want to sell shares to generate income. The only time I sell shares is to convert one investment into a stronger investment.

That’s why I apply the rule of 72 strictly to dividends, not capital appreciation. I would like to know how long it will take to recoup my initial investment solely from dividends.

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Let’s examine how I apply the rule of 72 across the six types of income investing. This analysis will provide a brief insight into how I evaluate products from the perspective of an income investor.

Closed-end funds. I typically purchase monthly-paying closed-end funds that yield at least 10%. Some of my favorites are Pimco Dynamic Fund (PDI, PDO, PTY), Eagle Point (ECC), and Oxford Lane (OXLC).

I like to know what each of the products offers that differs from the rest. I don’t want to overindulge in one area, like bonds or mortgages.

Preferred Shares. The rule of 72 shines best with preferred shares because you know the face value of the bond (usually $25). Therefore, you know you get a higher yield when the price is lower.

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If you purchase a $25 preferred share for $20, you significantly increase your yield and the rate at which you recoup your initial investment. In fact, I first learned about the rule of 72 in a book about preferred shares titled “The Billionaire’s Secret.”

Mortgage REITs. Most of the time, Mortgage REITs are out of favor. They look like beaten-down stocks for five or six years straight. However, they shine when interest rates are low.

When Mortgage REITs are out of favor (high interest rates), I like to find ones that yield at least 12-13%. To invest safely in Mortgage REITs, you must understand bonds and mortgages. My favorites are AGNC and Annaly Capital (NLY).

Business Development Companies. BDCs move almost opposite to mortgage REITs because they shine during times of high interest rates.

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I prefer to purchase high-quality BDCs when they yield over 10%. When interest rates drop, you can find BDCs at a discount, which is when you truly want to purchase. My favorites are Ares Capital (ARCC), Blue Owl (OBDC), and Capital Southwest (CSWC).

High-Yield Dividend Stocks. I love high-yielding dividend stocks, such as Altria (MO), AT&T (T), Verizon (VZ), and British American Tobacco (BTI).

These stocks yield above 6%, offer capital appreciation, and dividend growth. It may require more investment to achieve massive dividends, but they continue to grow due to the power of compounding.

Dividends ETFs. I view dividend ETFs differently than other income products because they offer high growth and low yields. I purchase these for what they will pay in the future.

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I love dividend ETFs because of their dividend growth rates and capital appreciation. They stand out versus my other products because of their unique blend of growth rate and share price appreciation. 

My two favorite dividend ETFs are the Schwab Dividend Equity (SCHD) and the WisdomTree High Dividend (DHS).

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Conclusion. The rule of 72 represents the direct link to the velocity of money. Therefore, the goal of income investing is to get the highest yield without sacrificing safety.

All investors should concentrate on how fast their initial investment will return; that’s why they call it “return on investment” or ROI.

I have been an income investor for six years, and I am still surprised by how fast my portfolio continues to grow.

If you want to change your circumstances, income investing offers a convenient way to generate passive income. However, you must study and focus on the velocity of money. Good Luck!

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