There are generally two types of investments that investors may use to make returns, growth
and income.
Growth is when the value of an investment like a stock or an ETF appreciates.
Some investors believe that growth investments might be the primary source of long-term returns
in a portfolio.
However, income-producing investments can help play a bigger role in growing a portfolio
over the long term.
Income-producing investment returns are risk-adjusted and may decrease volatility over long periods
of time.
That's because income investments entitle investors to regular payments, which help
offset volatility associated with growth investments like stocks.
These payments usually come in two different forms, interest and dividends.
Some examples of interest-bearing investments include money market accounts, certificates
of deposit, and bonds, among others.
The second form of income is dividends.
These payments are made to investors who hold preferred stocks or common stocks that pay
a dividend.
Dividends are a portion of a corporation's profits, which are then paid out to investors.
Corporations usually pay out dividends on a quarterly basis.
Dividend-paying stocks and interest-bearing investments are generally two types of securities
that may produce income.
Investors who own these securities can choose to either reinvest their regular payments
to compound the growth of a portfolio or use the payments as supplemental income.
Income-producing investments can play an important role in the long-term growth of all types
of portfolios.
That's because they're generally lower risk than other types of investments like
common stocks that don't pay dividends.
Sure, stocks can deliver exceptional returns from year to year, but they can also suffer
large losses.
And while returns from income-producing investments are generally lower, they can also be more
stable.
The stability of regular interest and dividend payments can help offset losses that can occur
in the stock portion of your portfolio.
Overall, income-producing investments help reduce portfolio volatility and provide a
steadier flow of potential returns over the long term.
So how do investors decide how much to allocate to their income-producing portion of their
portfolio?
There are many choices.
Generally, portfolios with higher allocations to income-producing investments may experience
steadier returns.
Conversely, portfolios with lower allocations to income-producing investments might experience
more volatile returns.
Deciding how much of a portfolio to allocate to income-producing investments depends on
several factors.
Two important factors are risk tolerance and time horizon.
Risk tolerance is the amount of volatility that an investor is willing to accept across
the entire portfolio.
Investors with a higher risk tolerance might allocate a smaller amount to income-producing
investments.
While investors with a lower risk tolerance could demand higher allocations to income-producing
investments.
Risk tolerance is linked to the portfolio time horizon by the volatility of returns
in a portfolio.
A longer time horizon usually means that an investor has time to absorb volatility in
returns and generally demand a lower allocation to income-producing investments.
A short time horizon, on the other hand, generally demands a higher allocation to income-producing
investments.
The goals with a short time horizon are to minimize volatility and maximize steady returns,
which income-producing investments can help accomplish.
Maximizing income and minimizing volatility are goals of many investors, which is why
income-producing investments may be a good idea for all types of portfolios.