Cash Flow is King
Recurring passive income raised to the power of compound interest.
My mission with WealthSystems.ai is simple: to demystify the sophisticated strategies and systems that the world's wealthiest families have used for generations to build and preserve their wealth.
The ultra-rich didn't become that way by accident.
They employ proven methods passed down over decades to generate consistent income, grow their capital, and maintain lasting prosperity.
So I am schematically breaking these down, explaining how they all work together, then helping everyone build their own Wealth System.
In today's post, we'll explore eight popular sources of investment income.
Every family I’ve worked with uses some combination of them.
A few use them all — the most aggressive about growth.
Each has its own unique benefits, drawbacks, and quirks that I'll explain in plain terms. My goal is to provide an unbiased comparison to help you make informed decisions. What may work well for one investor could be wholly unsuitable for another depending on individual goals, time horizons, and risk tolerance.
As with anything related to investing, it's critical that you do your own due diligence before jumping in. While I aim to provide a comprehensive overview, I can't cover every nuance in a single blog post. My advice is to use this as a starting point for further research. Discuss options with experts + stakeholders in your life to determine how potential income streams fit within the context of your broader portfolio and objectives.
Let's dive in and start with the ever-popular dividend-paying common stock.
Dividend Stocks Profit Sharing with Perks
If you want to generate income from stocks beyond just selling them at a higher price (good work if you can find it), dividends are your only hope.
Dividend paying stocks provide investors with a regular cash payment, usually quarterly, as a form of profit sharing. They represent partial ownership in a successful business that's sharing its success directly with you, the owner.
There are a whole group of monthly payers, semi-annual, annual, etc…
The typical profile of a dividend paying company is that of a large, established business with steady profits and relatively stable stock price appreciation.
Think major food and beverage companies, telecoms, utilities, and the like. These companies generate ample cash flow which enables them to reward loyal shareholders while still investing in future growth.
The dividend payments themselves are funded by the company.
Ideally these payments come from profits. Free cash flow that the company passes through to investors.
Sometimes companies borrow money to make these payments — that isn’t always a negative sign, but sudden changes in use of capital and sources of capital need to be monitored. Robbing Peter to pay Paul has not performed well historically.
For Paul nor Peter, ultimately.
Each quarter, management allocates a portion of earnings to dividends which are distributed equally on a per share basis. As an owner, the more shares you hold, the larger your dividend payments.
Most dividends range between 2-5% annually of the stock price though there are outliers on both ends of the spectrum.
You can spike your yield by having some investments with 8% to 10% annual return… but you also spike your risk. We’ll get to that.
Let’s talk taxes briefly first.
From a tax standpoint, dividend income is often treated favorably compared to wages or most forms of interest. Under current tax law, dividends are often considered "qualified income" subject to a maximum 15% or 20% tax rate depending on income level. This favorable treatment rewards investors for putting their capital at risk in stocks.
So what are some of the benefits of collecting dividends?
For starters, they provide steady cash flow on a predictable schedule. Dividends can supplement other retirement income sources or fund lifestyle expenses. The payments also allow you to realize a return without selling any shares, enabling you to maintain your ownership stake.
Another perk is that dividends are independent of underlying share price movement. Even if the stock price falls, your dividend remains intact allowing you to collect income while waiting for an eventual recovery.
Dividend paying stocks also offer growth potential through share price appreciation and future dividend increases. Successful companies tend to increase payouts over time as profits grow.
This boosts your income stream along the way + attention/interest in the company increases as they enhance their payout profile. This typically leads to capital appreciation - the stock price going up.
Lastly, dividend stocks are generally less volatile than non-dividend payers. The dividend acts as a form of valuation support by demonstrating that profits can sustain ongoing payments to owners. This results in lower price swings and reduced risk.
Some investors choose to tap dividends for income while reinvesting a portion back into additional shares through Dividend Reinvestment Plans or DRIPs.
This turbocharges the compounding process by growing your ownership stake and juicing future dividend payments.
Of course, dividend stocks come with drawbacks as well.
During recessions, it's not uncommon for companies to cut dividends to preserve cash when profits decline. This results in an income hit just when investors may need it most. However, most try to maintain or quickly restore payments after conditions improve.
There's also a tradeoff between dividend yield and growth. Stocks with higher starting yields often have slower price appreciation. Conversely, lower yielding growth stocks plow more profits back into the business to accelerate expansion.
Assessing this balance is key.
Overall, dividend stocks offer a relatively low risk way to generate predictable cash flow. When strategically selected and paired with growth-oriented stocks, they play an integral role in a diversified portfolio.
Up next we have a more complex cousin to everyday stocks... preferred shares.
Preferred Equity - Hybrid Income with Higher Priority
You can think of preferred equity as a hybrid sitting between stock and bonds.
Preferred shareholders own a piece of the company like common stock. However, preferred shares also have bond-like qualities that make them act more like fixed-income… another term for debt or bonds.
The key distinction is in how they are treated regarding dividends and claims on company assets. Issuers (the companies) pay preferred shareholders before common stockholders when distributing profits.
These dividend payments are usually fixed at time of issuance and paid quarterly. If the company omits or defers payments, restrictions kick in on things like common dividends until “preferreds” or “pref holders” or “the pref” are made whole again.
In case of liquidation, preferred shareholders also have a priority claim ahead of common stock on the proceeds from asset sales. This gives them a buffer compared to common shareholders who are last in line after all creditors and obligations are paid.
You'll typically find preferred shares issued by financial services companies as well as utilities and telecoms. They represent a way for businesses to raise capital without diluting common shareholders.
In exchange, they offer investors a higher and steadier stream of income.
How can preferred equity benefit you as an income seeker?
First off, the yields are consistently greater than dividends from common shares of the same company. Preferred dividends can run anywhere from 5-9% depending on credit quality and interest rates.
That's a major income upgrade.
You also gain priority over common stock dividends which are more vulnerable to reduction or suspension during downtimes. Preferreds put you first in line to receive your share of profits ahead of the commoners… but well behind Bond holders.
Even the Bond holders have security / preference and “creditors rights” documents that spell out their own special pecking order.
Additionally, some preferreds include a conversion privilege allowing investors to exchange the shares for common stock under certain conditions. This offers an added growth kicker if the shares convert to common at a favorable price.
On the downside, preferreds offer much less upside compared to common shares if the stock price takes off. The fixed dividend lacks an accelerant that rising common dividends provide. You trade away some growth for stability.
As income instruments, preferreds are also more susceptible to interest rate risk than bonds. Their prices tend to fall as rates rise, since investors can earn similar income from lower risk bonds.
Tread carefully in a rising rate environment.
Lastly, most preferred shares are "callable" meaning the company can redeem shares at par value after a set date. This pulls the rug out from under you if redemptions happen during a period of declining issuance.
Newer issues tend to offer richer yields.
Overall, preferred shares diversify an income portfolio with their hybrid nature bridging stocks and bonds. The higher starting yield and senior claim on profits reduces risk compared to common shares. Just keep tabs on the potential frustrations if you pursue these special stocks.
Shifting from individual securities, let's explore how REITs can deliver real estate income without the hassles of ownership.
Real Estate Investment Trusts (REITs) - Property Income Minus the 3am Phone Calls
Imagine collecting rental income, operating profits, and capital gains from real estate without having to physically buy or manage any properties.
This is essentially what Real Estate Investment Trusts (REITs) offer investors.
REITs are companies that own and usually operate income-producing real estate. This includes apartment buildings, office towers, hospitals, shopping centers, hotels, you name it. They allow individual investors to gain exposure to these assets through buying shares of the company, just like any stock.
What makes REITs unique is favorable tax treatment if certain conditions are met.
To qualify, they must derive at least 75% of gross income from real estate related sources and distribute at least 90% of taxable profits annually via shareholder dividends.
This effectively avoids taxation at the corporate level.
Shareholders then pay taxes on their qualified dividends and any capital gains. This is the tradeoff for access to commercial real estate profits and diversification in an easy-to-buy structure.
There are several flavors of REITs to choose from:
Equity REITs own and operate properties generating income from rents and asset appreciation.
Mortgage REITs loan money directly to real estate owners earning income on the interest.
Hybrid REITs do a mix of both.
REIT dividends can range anywhere from 3-10% annually depending on the sector and mix of assets. Yields from triple net retail tend to fall on the lower end while self storage and industrial REITs are up the scale.
Besides immediate cash flow, REITs provide a few other advantages as an investment.
Firstly, the diversification benefits are huge compared to owning just a few physical properties. REITs allow you to spread risk across hundreds of assets across multiple geographic markets. Your income stream won't crater if an individual property hits a rough patch.
They also provide liquidity unlike directly owning real estate. You can buy and sell shares easily any day the stock market is open. Try doing that with an apartment building or data center. The flexibility is unmatched.
Lastly, mixing REITs into a traditional stock and bond portfolio enhances diversification and reduces risk-adjusted returns.
Those tidy dividends help smooth out the overall volatility.
Downsides of REIT investing revolve around interest rates, cash flow variability, and taxation. REIT share prices often fall when rates rise since it makes the dividends look less attractive. Higher rates also increase financing costs creating a headwind for earnings.
Given the nature of property ownership, earnings can also fluctuate significantly when markets hit a rough patch. Income from hotels or retail will take a bigger hit during recessions compared to more stable sectors like apartments or cell towers. This cash flow uncertainty dampens the appeal.
Overall, REITs provide a solid way to diversify your portfolio into real estate without the capital or operational baggage that comes with direct ownership.
Shifting from real estate, let's wade into the high octane world of energy infrastructure and MLPs.
Master Limited Partnerships (MLPs) - Fueling Income with Tax Advantages
If REITs unlocked real estate investment through a corporate structure, you can think of Master Limited Partnerships (MLPs) doing the same for energy infrastructure assets like pipelines, storage terminals, and processing facilities.
These partnerships own hard energy assets while trading on public exchanges just like stocks.
What really powers MLPs is their tax structure.
As partnerships, they don't pay taxes themselves. Earnings are only taxed when they pass through as distributions to individual unit holders.
This elimination of double taxation at the entity level gives MLPs more cash flow to distribute than typical corporations.
In exchange for this tax advantage, MLPs are required to derive at least 90% of gross income from energy investments and pay out most of earnings in distributions.
This results in chunky dividend yields typically between 6-12% annually.
The qualifying income limitation focuses most MLPs squarely on midstream energy infrastructure needed to transport oil and gas from point A to point B.
For investors, the MLP appeal starts with those juicy distributions. Locking in yields above average stock dividends provides a healthy income stream, especially when reinvested.
Given their tax structure, MLP yields are frequently on par with interest payers but represent ownership of vital energy assets with appreciation potential. That's a win-win combo.
Another benefit lies in the inflation hedge MLPs can provide over time. As commodity prices rise with inflation, MLPs increase their fees for services accordingly. Products like oil and gas closely track inflation giving MLP distributions room to grow over time compared to fixed payers.
That being said, the inflation hedge is not perfect and works with a lag. When commodity prices spike too quickly, MLP distribution growth struggles to keep up immediately. But over the longer term, the protection tends to prevail.
And we are thinking multi-generational empire building right?
Good.
On the flipside, taxation of MLP income does create some complications come tax time.
Rather than receiving the usual 1099 form, investors get a dreaded K-1 statement outlining your share of partnership income, deductions, credits, etc. If you own multiple MLPs, it can get unwieldy to track and report correctly.
Most advisors recommend holding MLPs in tax advantaged accounts to avoid the paperwork migraine.
MLPs are also volatile along with the energy sector they serve.
When oil and gas prices crater, like in 2020, MLPs face rapidly declining demand for their transport and storage services. Distributions take a hit and won't satisfy investors seeking steady income. Adding MLPs to a portfolio definitely juices overall risk and volatility measures.
There's also regulatory risk given the tax advantage. Any change in law undermining or removing the tax benefits would seriously impair the MLP equation.
Many conservative investors choose to avoid this policy uncertainty.
Overall, MLPs offer a niche opportunity for above average income that demands specialization. If you have the risk appetite, tax situation, and desire for an inflation edge, MLPs can be rewarding.
Now let's examine how online lending platforms have opened the door for individuals to earn attractive interest by funding personal loans.
Peer to Peer Lending (P2P) - Earning High Interest from Individual Borrowers
Imagine a world where you could lend money directly to a borrower in need from the comfort of your living room. The days of needing a bank branch and loan officer to earn interest are fading thanks to peer to peer (P2P) lending platforms.
P2P lending directly connects investors looking for yield with individual or small business borrowers looking for affordable loans.
Cutting out traditional bank intermediaries allows borrowers to secure loans at lower interest rates while investors can still earn attractive returns for taking on the credit risk.
It works like this: an investor opens an account with a P2P lending platform like LendingClub, Prosper or FundingCircle.
You select the types of borrowers you're willing to lend to based on risk, geography, purpose, etc. The platform then matches you with borrowers seeking loans that meet your filters. You invest capital across multiple loans to diversify risk rather than tying up all your money with a single borrower.
As borrowers make their fixed monthly payments, you receive interest income minus any fees the platform charges. P2P platforms handle all the payment processing and debt collection on your behalf. The hands-off approach creates a steady income source without ongoing management.
Returns ultimately depend on the profile of borrowers you fund and the prevailing default rates across the platform. Annual returns typically range from 5-12% for qualified borrowers down to 2% and under for highly risky borrowers. The lower your minimum credit standard, the higher your potential returns and chance of losses.
Spreading money across multiple loans helps smooth out these risks.
Compared to traditional fixed income, P2P offers a major advantage in yield enhancement. The best savings accounts and CDs currently hover below 2%. Bonds aren't much better.
P2P lending blows these away provided you have the stomach to handle some defaults.
This higher income does come with tradeoffs, however. First and foremost is credit risk. Since P2P loans are unsecured, there's no collateral backing them up. If a borrower stops paying, you're left holding the bag with potential for total loss. Having funds spread thin across too many loans can quickly devastate your returns if defaults rise.
Tread carefully assessing credit limits.
Liquidity is another shortfall.
Your money is tied up for the full term of each loan, usually ranging from 1-5 years. Early loan repayments do free up capital to reinvest sooner than expected, but you can't readily cash out like stocks or bonds. Make sure you don't funnel money you could need in a pinch.
Lastly, P2P remains a newer industry still working to standardize practices and regulations. Any major changes in oversight or platform stability could upend the platforms. We saw this in 2020 when loan issuance dried up during COVID-related shutdowns.
Growing pains are inevitable.
Overall, P2P lending opens the door for motivated investors to turbocharge stagnant fixed income returns.
I’ve stopped using these lending sites because they offer limited protection or diligence capability to me.. but they take a piece of the action for NONE of the risk.
Smart business model for them. Doesn’t work for me.
I work with smart people every day, sometimes they need capital to inject into an idea or business… thats where my lending opportunities come from.
Transitioning from lending money, let's explore how call options can create income from stocks you already own.
Covered Calls - Income Boosters with a Catch
If you own a chunk of dividend paying stocks, here's a clever way to juice your income.
Selling call options against your holdings brings in premium income in exchange for obligation to sell your shares.
Here's a quick options refresher: a call option gives the buyer the right, but not the obligation, to purchase an underlying stock at a set "strike" price before an expiration date. The seller collects an upfront premium for taking on this obligation.
With covered calls, you first own the underlying shares. You then sell/write call options against your position to collect the premium.
If held until expiration, one of two outcomes unfolds:
The stock price stays below the strike price so the option expires worthless. You keep both the shares and the full premium.
The stock rises above the strike price so the option holder exercises their right. You must sell your shares at the fixed strike price. You keep the premium plus any share appreciation up to the strike price.
The major benefit of covered calls is amplifying income during sideways or down markets.
The steady premium collections add a nice boost to dividend payments.
This extra cash flow softens the blow when share prices stagnate or decline slightly. Selling calls allows you to generate returns independent of fickle stock moves.
Covered calls also provide some downside protection if done methodically. By selecting lower strike prices, you guarantee being able to sell your stock above the market price if exercised. This cushions the loss relative to doing nothing. Sure you lose out on upside beyond the strike price, but you protect capital in exchange for limited gains.
You can also strategically sell calls above your purchase price to guarantee profit even if shares get called away. If the stock rises above your breakeven, rest assured you'll lock in the gain. Compare this to an uncertain ride of just hoping prices recover after a substantial decline.
That limitation on the upside does remain the major drag of covered calls, however. You cap your participation in any substantial rally in exchange for the premium income. Great in theory when stocks move sideways but less ideal if a breakthrough materializes.
Covered calls also require a higher level of trading sophistication and monitoring than simply holding dividend stocks. You must continually sell calls on a monthly or quarterly basis to keep income flowing consistently. It's an active strategy unfit for the passive investor.
You can use robotic systems to do this for you.
At the end of the day, employing covered calls should come down to your risk tolerance and objectives. For conservative investors focused on income stability and capital preservation, covered calls make sensational add-ons. Those with higher risk appetite wanting unlimited upside may find them too constricting.
Overall, covered calls offer useful income enhancement and downside cushioning for long-term stock investors. Just know the tradeoffs and risks involved before leaping in. When used selectively on the right stocks, covered call income can meaningfully boost total returns.
Shifting gears, let's explore how collar options allow you to generate income while protecting against loss.
Writing Collar Options - Hedging Risk for Premiums
If you want to earn income from options while protecting against loss, combining a protective put with covered calls may do the trick. This bundled package is known as a collar option strategy.
Here's how they work:
You start by owning shares in a stock.
You then purchase long-dated put options below the market price. This puts a floor under any potential declines.
To offset the cost of the protective puts, you sell calls above the market price. This caps your upside if exercised.
The proceeds from selling calls partially or fully fund the purchase of puts depending on strike prices.
The combined result is downside protection from the puts, upside limitation from the calls, and net income from the call premiums exceeding put premiums. It's a ingenious way to generate income while defining risk parameters through options.
During periods of elevated volatility or uncertainty, collar options allow investors to remain in a stock position they otherwise may have exited due to losses. The protective puts remove the open ended risk of owning just the stock itself.
For example, if you buy puts at 90% of the share price and sell calls at 110%, you create a range where the maximum loss is 10% and maximum gain is also capped at 10% above today's price. The premium income reduces the net cost of protection.
Beyond direct income, collar options offer psychological benefits by delineating clear risk boundaries. You know the minimum and maximum outcomes in advance rather than white knuckling each uptick and drawdown.
Many investors sleep easier at night after collaring volatile holdings.
The protection does limit returns, however, in the event your stock shoots well past the call strike. You leave significant money on the table buying insurance against a decline that never materializes.
The opportunity cost can be steep.
Then again, peace can be invaluable in certain circumstances.
Complexity is another barrier for newer option traders. Optimal strike selection, expiration dates, and timing require experience to implement smoothly. Paying attention to quarterly earnings dates and other catalysts ensures you maximize income. There's a learning curve to master.
Lastly, buying long dated puts outright can require a big cash outlay upfront. Portfolio size limits how many protective puts you can affordably purchase to hedge multiple holdings. Larger investors have a clear advantage implementing collars.
That’s why I always implemented this at the family offices I managed:
Overall, collar options allow motivated investors to generate income while carefully defining risk parameters. In volatile times, collars can ease nerves and enable staying power.
Given the complexities, make sure to learn the ins and outs before diving head first into collar strategies. When applied diligently, collars demonstrate the power of options to tailor outcomes.
Shifting from publicly traded securities, let's explore how investing in the obligations of distressed companies offers unique income opportunities for adventurous investors.
Distressed Debt - Boldly Pursuing Profits in Bankruptcy
The previous income sources largely focused on highly liquid securities from reputable issuers.
Now let's delve into the wild world of distressed debt where lack of liquidity is just one of many hazards.
Distressed debt investing involves purchasing bonds, loans, and other obligations of companies in significant financial trouble far below face value. The goal is to profit when the business restructures and recovers by selling at a higher price or swapping the debt for equity.
Returns stem from buying debt at massive discounts during periods of uncertainty.
For larger companies, bonds may trade as low as 10-30 cents on the dollar during bankruptcy reflecting the possibility of total loss. Investors aim to cherry pick obligations most likely to retain value after restructuring.
Active involvement is often required to influence events in your favor. Investors collaborate to form creditor committees and inject new financing to turn companies around. These high effort tactics increase the chances of profiting. Passivity means leaving outcomes to chance.
Due to extreme volatility and legal complexities, distressed debt investors tend to be highly experienced. Patience and steel nerves are required while events play out over months or years. The eventual payoff can be windfall gains that justify the stress.
For instance, a $10 million bond purchase at 20% of face value yields a $2 million investment. If restructured at 80% of face value, the investor recovers $8 million on the original $2 million bet. That's a 4x return rivaling great private equity home runs. And it was achieved lending money rather than traditional equity ownership gaining upside.
These mammoth returns do not develop without accompanying risks, of course.
The lack of liquidity also means you're stuck holding the bag once invested.
Trying to exit early requires even steeper discounts since buyers know you're under pressure. Takeaway: only allocate what you're willing to lose to distressed debt's rollercoaster ride.
Choosing the wrong obligations that get wiped out or overly diluted leaves investors with massive losses. A wrong turn in a complex bankruptcy can instantly vaporize months of progress.
Court is expensive, takes forever and the outcome is uncertain.
Not a friendly set of factors for a professional investor!
Lastly, understanding bankruptcy law is paramount to promoting favorable outcomes and avoiding pitfalls.
Distressed investing is one of the few areas where legal expertise creates a durable edge and doubles success rates. Amateurs tend to get steamrolled by experienced lawyers on the other side.
Overall, distressed debt offers tantalizing profit potential for battle hardened investors able to stomach the risks. The highest returns accrue to those putting in the work to turn around troubled stories rather than blindly speculation on a recovery.
If you've got the constitution to go where few dare to tread, distressed debt delivers.
The Fully-Funded Finish Line
There you have it - eight diverse options for generating investment income.
As you can see, the days of brainlessly parking money in CDs and money markets are long gone if your objective is meaningful cash flow.
The alternatives vary widely in risk profile, complexity, taxation, liquidity, and income levels.
What may perfectly suit one investor could be anathema to another. True diversification requires spreading investments across multiple income sources tailored to your specific goals.
While I aimed to provide a balanced overview of popular options, I strongly encourage additional research before pursuing any strategy. Discuss with a fee-only advisor to map out a prudent allocation befitting your broader financial situation. Blazing new income trails demands care to avoid pitfalls.
Our mission here remains crystal clear - shining light on sophisticated wealth generation techniques used for generations by ultra high net worth families and individuals. Never be afraid to question status quo thinking and employ the strategies of the affluent.
I have now given you enough tools to build your own Wealth System.
In our upcoming series, that’s exactly what we are going to do — design our own.
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