A few days ago a reader asked me what portfolio income is. I love this question. At it’s basic level this is the income you derive from your portfolio. Pretty straight forward so far but let’s go deeper. Together, we’ll look at what this really is (and how to increase portfolio income too.)
In order to really understand the term “portfolio income” we have to understand a few other concepts.
What is a portfolio?
Your portfolio is the accumulation of all your investments but depending on how you qualify it, the term could refer to many different assets and asset classes. If you talk about your overall portfolio, that would include all real estate (other than your residence), savings, retirement accounts, debts owed to you, collectibles, business interests etc. The whole ball of wax.
If you talk about your investment portfolio that generally refers to all liquid investments in stocks, bonds, mutual funds, etf’s etc. That would include retirement accounts and non-retirement accounts. If you talk about your retirement portfolio that would include all investments that you are using or are going to use to create retirement income. That might include real estate (including your residence), stocks, bonds etc. And if you talk about your business or real estate portfolio that would include any and all small business interests you own or any real estate you own.
Notice that your portfolio (overall, retirement, investment, real estate or business) doesn’t include any debt. So you could have a huge portfolio but if you also carry large debt, you could still have a negative net worth and possibly a negative net income too.
What’s interesting about the size of your portfolio is that it generally indicates how much gross income you might be able to generate – and that leads us to the next phase of our definition.
What is income?
This is actually a fascinating question and it’s not as simply as it may seem. “Income” could mean many different things as well. Gross income is the total amount you take in. Net income is much more fun. That’s the amount you get to keep. For example, a real estate rental might generate $40,000 in gross income a year. But if your expenses are $42,000, you generate a negative $2,000 a year. That’s not so exciting.
When you invest in bonds you usually refer to the interest as the income. So, if you have a bond portfolio, the portfolio income would be the bond interest. That’s pretty straight forward.
The difficulty arises when you think about portfolio income from stocks or growth mutual funds. When you own stocks (or funds that own stocks) some pay dividends and that certainly qualifies as income. But what about stocks and funds that don’t pay dividends? Can you derive income from such a portfolio? You absolutely can. And as a matter of fact, this has been one of the best ways to create income for people who want to have a secure retirement.
People who use growth stocks or funds to create income simply take out a fixed amount of the portfolio every year – say 4% – regardless of how well the stocks or funds perform. In years where the stock grows quite a bit, that 4% increases because the base is larger. In years where the stock is decreasing, the 4% declines because the base declines. Look at the chart above. It shows what the income would hypothetically look like had you invested $100,000 in the S&P 500 in 1988 and derived income from your portfolio at the rate of 4% every year.
You can see that this approach isn’t perfect. There are some years where the income rises dramatically and other years where it declines radically. From 1999 to 2002 your income dropped from $21,000 a year to $11,000 a year. Ouch.
But if you look at the result over many years, the income isn’t bad at all. In fact, the portfolio income from this investment works out to be $14,000 – which is 14% of your initial investment.
You can see that there are many ways to create portfolio income. Many times financial writers and advisors throw around terms such as portfolio income without bothering to define it – myself included. I’m delighted that a sharp reader called me on the carpet and gave me the opportunity to explain this term because it’s very important.
Are your investments generating portfolio income? Why or why not? What are you going to do about it?
Ronald Dodge says
Me personally, I’m not a fan of using mutual funds as they not only have the fees that’s posted in the prospectus, but also hidden fees. As to using funds within a 401(k) plan, I didn’t have much of a choice if I also wanted to get the employer’s matching on it. In the early days, that matching can defray the total fees charged by the mutual fund managers (which I found to be around 2.00% annually even though prospectus said either 0.50% or 0.75% annually). However, as that account gets growing, eventually, that matching policy can no longer defray those mutual fund fees.
I started out with just $1,000 in the stock market outside of the retirement account. Over the 6 years of having both accounts, my own investments outside of the 401(k) plan were trending 1% above respective investment benchmarks while my investments in the 401(k) plan were trending 2% below respective investment benchmarks. The only other positive you could draw from with the 401(k) plan, it wasn’t as volatile as my own investment outside of the plan was, but that 2% below respective investment benchmarks was pretty clear to me. On the other hand, if you are thinking long-term with regards to retirement accounts, that 3% difference between the 2 set of investments should be what really matters as time rounds out the volatility of investments over time meaning if you ride the rollercoaster of ups and downs and not let your emotions about the downs get in the way, then the ups and the downs should essentially cancel each other out.
When you think about it, with a 3 percent difference in the margin is pretty significant. Let’s say hypothetically, when you enter the work force, you start out earning $50,000 annually, and your income goes up 3% annually until you retire. Let’s also say the stock market returns 10% annually, thus the 401(k) plan only returns 8% annually with a matching policy of 100% up to the first 6% of gross income, and the Traditional IRA returns 11% with no matching. On more thing, 15% of your gross income goes into retirement fund(s) for a period of 40 years.
Scenario 1: Put 15% of gross income into 401(k) plan for all 40 years, thus effectively getting 21% of gross wages or just shy of 20% of “Actual gross earned income” (.21/1.06).
Scenario 2: Put 15% of gross income into a Traditional IRA with no matching for all 40 years.
Scenario 3: Put 6% of gross income into 401(k) plan and 9% of gross income into Traditional IRA for all 40 years.
It is only the first 2 years scenario 1 is giving more interest income than scenario 2.
By year 21, scenario 2 has more assets than scenario 1, while scenario 3 is still getting more residual income than scenario 2.
Year 23, scenario 2 and scenario 3 get about the same amount of residual income with scenario 2 taking over in year 24.
Year 37, the assets in scenario 2 is about equal to the assets in scenario 3 with scenario 2 taking over in year 38.
In the end, it seems as though unless you really know you going to be working for one specific company for practically your entire work career with this sort of scenario, you would go with going with the option of taking scenario 3, max out the employer’s matching policy, and then put the rest into either a traditional IRA, ROTH IRA, or some combination of both depending on your set of circumstances. I know technically, you can only put up to a maximum of $5,000 into either or combination of both IRA unless you are 50 or older, then up to $6,000, and that’s per person basis, so if you are married, you could still get $7,500 put into IRAs between you and your spouse within a single year. As such, scenario 2 would still work in that case.
MultimillionaireRoad says
If you check out my site. In June I wrote a post entitled Multimillionaire Road Review 2. On that site I’ve outlined my portfolio thusfar. I understand if you don’t have the time to fully analyse it. Any help would be appreciated.
MultimillionaireRoad says
Sorry I know that was long but would appreciate a long discussion on the topic. Maybe I’ll write a post when I begin my portfolio and trace its progress.
MultimillionaireRoad says
Whilst I have not started making a dividend yielding share portfolio, that is my aim over the next 30 years. I am based in the UK. What do you suggest is the best way to start? What shares should I be looking at? What in the annual reports should I be focusing on?
Neal Frankle says
I can’t give specific advice. But why not start with a mutual fund? What is the size of your portfolio? How much can you save monthly?