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?