When it comes to generating an income from your investments, the usual suspects are interest and dividends.
Interest allows the value of your portfolio to grow over time, which can then either be reinvested to increase your total holdings, or withdrawn to spend on life’s other expenses.
Meanwhile, dividends give you a one-off payout for certain reasons ranging from good financial performance, to mergers and acquisitions.
Both are an opportunity to release some cash from your portfolio, without having to sell any of your stocks; however, they are not the only ways to generate income.
Relying on interest to generate an income for you is risky. Rates can go up and down, and often fall at times when the economy as a whole is struggling – just the time when you might want to derive more of an income from your investments, not less.
You can reduce your exposure to volatility using fixed interest investments, but these often start out by paying less in return for the increased confidence.
And during a period when interest rates are rising, locking into a fixed interest investment can actually leave you with declining real-terms value in your portfolio.
On top of this, there is the question of what happens when those fixed interest investments mature: will there be an equivalent product available to replace them without losing further value?
If a suitable alternative is not available, you run the risk of a significant impact on the level of income you are able to generate – called reinvestment risk, as it occurs when you have a matured bond or similar sum to reinvest.
Dividends are, if anything, even more risky than interest. There is often little confidence in the amount of dividend that will be paid by an individual stock, and some dividends are one-time payouts that will not be repeated on a quarterly or annual basis.
There is also the problem that dividends are usually paid quite infrequently, so even a repeating dividend might only pay out once a year when financial results are announced.
You can hedge against this by holding multiple stocks that pay their dividends at different times, but it’s not ideal to invest according to schedule rather than value, and you may need to invest relatively large amounts into each stock to achieve a significant dividend payout.
And because the best dividend-bearing stocks tend to be found within the same few most valuable sectors in the economy, the options for diversification of your portfolio as a whole can be limited too.
What are the alternatives?
One alternative is to invest in equities that you regularly sell in order to generate income. Managed well, it’s quite possible to withdraw cash on a regular basis while still achieving long-term growth.
The money made by selling equities is classed as a capital gain rather than as income for tax purposes; however, it still represents disposable income in real terms if you use this method on an ongoing basis.
It’s important to be sustainable about selling off parts of your portfolio. The temptation can be to sell off the highest value stocks, but this will gradually diminish the quality of what’s left.
Because you are continually removing value from your portfolio, you also rely on the markets to grow fast enough to replace that value.
In essence, whatever you withdraw – whether it’s 1% or 10% or more – puts your portfolio in ‘negative equity’ in terms of growth, even before factoring in the gains and falls of the markets.
That being said, a strategy based on selling equities can return more in disposable income over the long term than relying on fixed interest and dividends – and it can be much easier to achieve overall growth in the long term this way too.
All of the usual ways to hedge your portfolio apply, such as investing in a mix of different risks and volatilities, as well as in funds with different liquidity rates so that you can get at least some of your cash out quickly in a crisis.
Over the long term, it’s sensible to keep a rainy day fund in the bank rather than investing every penny, so you can pay the bills for at least several months without liquidating any stocks.
This has multiple benefits, allowing you to invest in less liquid stocks if they offer a better return, and ensuring you are not forced into selling at less than market value when you need to generate some income.
In fact selling at a loss can be a useful tactic in itself, as this offsets capital gains made elsewhere, and can prove beneficial for tax planning purposes.
Diverge and conquer
Diversification is generally a good hedging strategy in any investment portfolio and allows you to generate income in a variety of different ways and at different times of year.
A diverse portfolio might contain some interest yielding investments, along with others that pay a regular and relatively reliable dividend.
You might spread those dividends throughout the year to ensure your income does not all come as one lump sum at the same time.
And by selling equities as part of your ongoing approach to portfolio management, you can add capital gains to the income you derive from interest and dividends.
This gives you a third source of money on a regular ongoing basis, while still allowing your portfolio to grow – increasing your flexibility, real-terms liquidity, and protection against isolated risks.
Disclaimer: The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.