Planning for today and tomorrow
You often hear from us that investing is a long-term endeavor -- a marathon, not a sprint -- and that you should invest toward your long-term goals. All of that is true (of course), but today we’re going to talk about how certain investments can also help you meet your short-term income needs.
Investing to generate an income stream
Investors who have minimal sources of income or who want to supplement their income, such as those in retirement or between jobs, often rely on their investment portfolios to generate short-term income. If you need your portfolio to generate income today while also potentially growing your money for the future, you need the right asset allocation of stocks and bonds, which requires some careful planning.
Finding the right investment yield (income)
There are many types of investments that can generate “yield” – a term synonymous with income. The yield an investment offers depends on its risk level and can change over time. Careful consideration is needed to determine if the yield on an investment is worth the risk.
Bonds typically help you generate income, while stocks typically help you grow your money over time, but some stocks, specifically those that pay investors dividends, can also offer income. In general, there are two types of investment income: interest and dividends.
Interest income from bonds
By investing in bonds and bond exchange-traded funds (ETFs) or mutual funds, you can receive interest income on a periodic basis (as long as the bond issuer continues to be able to make its interest payments). In effect, investing in interest-yielding bonds converts the money you invest today into a relatively reliable stream of income that can be used to pay expenses.
The rate of interest and frequency of payments is specified by the bond or investment vehicle. Typically, the interest or yield offered by a bond correlates to the safety of the bond. Riskier bonds pay higher interest rates, while safer bonds offer lower interest rates. The higher interest is compensation for taking the additional risk; however, because these investments are riskier, there is increased chance that the issuer may not be able to meet its obligation to pay back the bondholder. You can learn more about the risk and return of different bond types in our recent Lionomics post, "What’s the best way to invest in bonds? "
Dividend income from stocks
Income can also be generated in the form of stock dividends. Dividend income is paid to stockholders of a company, usually in the form of cash. That means you can receive income from holding stock while also potentially benefiting from rising share prices over time. However, compared to bonds, there are fewer “certainties” around dividend payments for stock. Companies can decide to decrease or discontinue stock dividend payments if their profitability declines or if they want to use that money for company growth. On the other hand, they can also choose to increase dividend payments, or pay “special dividends,” if they are doing well.
Balancing your short- and long-term needs
Weighing your short-term income needs against your long-term growth needs is important when choosing the right stock and bond allocation. Take a look at the guidance and helpful chart in our post, “Should I invest for growth or income?”
If you’re seeking to generate investment income today, it’s important to consider today’s low (but rising) interest rates. Buying investments that generate income at relatively low rates may not be wise if doing so prevents you from buying investments that can deliver longer-term returns (albeit that may not generate income). Your personal investing time horizon is an important consideration here as well.
Interest and dividends are just one part of your total return
While interest and dividends can be valuable sources of income, it’s also critical to remember that these aren’t “free” sources of income. Your interest and dividends are components of the total return you receive for investing in certain stocks and bonds. In other words, when assessing your ideal asset allocation, income is only one of many factors to consider.
One additional issue to consider is the tax consequence of receiving income. Any interest or dividend payment you receive is taxable in the year it is received. Thus, receiving income from your investments would require you to pay taxes on that income today, rather than paying taxes on any realized gains from selling stocks in the future. This is yet another reason it’s important to carefully consider how much income you need and whether you truly need it today.