Welcome to the World of Income Investing

 

Yes, You Can Be a Successful Income Investor by Ben Stein and Phil DeMuth is a great introduction to income investing. This book covers the basics income investments available to investors which include:

• Bonds
• Stocks
• Preferred Stocks
• Real Estate Investment Trusts (REITS)
• and Annuities

Armed with this knowledge you can start to build your own income producing portfolio. One of my goals is to completely replace my earned income with passive (portfolio) income. I've estimated that in order to do that I'll need a portfolio worth approximately $800,000. Although this sounds like a lot, reaching this goal will become easier as the portfolio grows. This is because the income the portfolio produces grows as the portfolio grows, accelerating its growth (given that you reinvest all the income that your portfolio produces).

One important thing to note is that as your income portfolio grows you should be investing in lower risk income options, such as bonds. My recommendation would be to invest aggressively at first, when your portfolio is relatively small, then over time as your portfolio grows invest into safer, lower yield investments. As you're closer to reaching your goal it will be more about capital preservation than growth.

Here's some advice from Ben Stein:

Index Fund Investing

There are a lot of options out there when it comes to investing your money. The RRSP deadline has recently passed and those of us who have contributed to our RRSP's were probably bombarded by a ton of choices. Index funds are your best choice when it comes to keeping investment costs and portfolio turnover low, which is the key to investment success.

 A good example of an index fund portfolio is to own three indices:

1. Candian Bond Index
2. TSX Composite Index
3. Dow Jones Industrial Index

The amount you allocate to each will depend on a few factors such as your risk tolerance and your time horizon for your investment. More weight should be towards bonds and less to equities (stocks) if you are risk adverse or if the money is needed relatively soon. A rule of thumb is to use your age as the percent allocated to bonds, i.e. the younger you are the more you should have invested in riskier (potentially more rewarding) equities.

The key is once you've chosen your allocation, you rebalance your portfolio no more than once a year to maintain the same allocation (thus forcing you to buy low and sell high). As your portfolio grows in size it may be advisable to add a few more indices such as a European Index or Japanese Index, this will add another level of diversification to your portfolio and a few more asset classes to rebalance.

Just watch this short video and hopefully you'll agree that index funds are the way to go:

What's the Big Secret to Riches?

There are two schools of thought when it comes to investing in stocks. One is growth and the other is value. Warren Buffett believes that these two strategies are "joined at the hip" and that you cannot think of them separately. So what are the main differences between these two types of investment styles.

A growth investor is looking for companies that are expanding quickly. Typically these companies don't pay a dividend since the earnings are reinvested into the company so it can "grow" faster (such as Research in Motion). Whether the funds are used to grow the company faster than you could by investing the earnings elsewhere is questionable. In this case you are looking to buy these companies at a high price, hoping that the price will continue to climb.

Value companies on the other hand are companies that have good valuation metrics such as price to earnings or price to book value. Value purchases are made when the economics of the industry may be out of favour or the company has hit some kind of snag that is solvable. Usually the price will reflect these uncertainties and for that reason it may appear to be a bargain (but be aware it might be cheap for a reason). Value companies tend to offer a dividend which can be invested elsewhere or can be used to maintain your quality of life. In this case you are looking to buy low and sell high (although you could hold on to the stock for it's sweet dividends).

So what is the best investment strategy. In "The Big Secret for the Small Investor"by Joel Greenblatt, he makes a strong argument that value investing is the way to go. Be warned that I am biased, I would classify myself as a value investor so I tend to read books about value investing. This book is more than just a sales pitch for value investing, it gives deeper insight into an age old strategy of investing known as index investing.

Index investing is when you purchase mutual funds or ETF's that mimic the entire market index (TSX, NASDAQ, DOW, or S&P 500). This is a great passive way of participating in the market that will be sure to beat approximately 70% of actively managed portfolios (most of which is due to the low management fees, low portfolio turnover and transactional costs). When it comes to finding the perfect stock it can be analogous to finding a needle in a haystack, so index investing is like purchasing the whole haystack. Greenblatt goes above and beyond by testing out different index fund strategies.

Something he's noticed is that market indices are usually market capitalization weighted, meaning that as a singular stock price rises, the index causes you to own more of that stock. So what if that stock is overvalued? In this case your portfolio would be over weighted in overvalued stocks and we all know what happens when a stock is overvalued. The price increase won't continue forever and when bad news eventually surfaces a price crash ensues.

So what's the best solution. Consider an index fund oriented towards value investing, which would set up the weighting of your portfolio a little differently. Causing you to buy more of what is out of favour so you purchase more undervalued stocks (buying low selling high). This balances out your portfolio and produces higher rates of return in the long run.

Here are some wise words from the Oracle of Omaha himself: