Masters Series: Doc Eifrig's Six Timeless Rules of Income Investing

Doc Eifrig's Six Timeless Rules of Income Investing

By Dr. David Eifrig, editor, Income Intelligence

Rule No. 1 – Buy Value

If there's one thing income investors should constantly remember, it's buy value. By that, I mean you should always pay a fair price for what something is worth.

It seems simple. But it's the first thing investors forget. The hot stock tip or brand-new technology story can quickly push a stock's valuation into the atmosphere.

For every investment you make, you should write down a compelling argument for why it's undervalued. Maybe the stock is cheaper than its competitors... or the market as a whole. Maybe it has a better product than its competitors do. But whatever your reasoning is, you should force yourself to do this exercise every time. It will keep you away from investing in popular, overvalued stocks.

Rule No. 2 – Don't Chase Higher Yield

One of the temptations facing income investors is to purchase high-yielding investments. But the truth of the matter is, the overwhelming majority of these stocks are not worth investing in. The few extra percentage points of yield come with far more risk than we're willing to accept in Income Intelligence.

Instead, we look for opportunities that pay safe, steady streams of income. That helps us keep our risk low... while still collecting healthy income payments.

A good rule of thumb is that once an investment reaches a double-digit yield, you're well into high-risk territory. So never start your search for new investments based on the highest yields possible... unless you just want to gamble with your money.

Rule No. 3 – Understand How Your Asset Makes Money

Income investments are just different ways to package productive assets.

Real estate investment trusts (REITs), for instance, generate income by renting out real estate and passing on the rent payments to shareholders. Master limited partnerships (MLPs) own industrial assets like oil pipelines and similarly pay shareholders a percentage of the fees they generate.

To properly invest in these income markets, you have to understand the underlying assets. That doesn't mean you have to become an expert in real estate or oil pipelines.

As long as you invest over a longer-term time frame and you're buying into established, profitable businesses, there are only three things you need to know about the underlying assets...

Of course, those three questions are important to note for any investment... but they are especially relevant to income investors.

You need to know how the health of the economy will affect your asset. During recessions, some income investments may have to cut their payments. For instance, stocks may see lower earnings and be forced to cut their dividend payments.

By spending a short amount of time thinking about the assets you're buying and the economic environment, you can make sure both your income and your capital are safe.

Rule No. 4 – Asset Allocation

One of the keys to successful income investing is proper asset allocation, how you balance your portfolio among stocks, bonds, cash, real estate, commodities, gold, and other investments.

If you keep your entire net worth in stocks and the market pulls back, you'll suffer badly regardless of what stocks you own. Likewise, if you hold your net worth in gold and it falls $100 an ounce, your lack of asset allocation will hurt you.

Concentrating your retirement nest egg into just a few stocks or a few asset classes is far too risky. One of the simplest ways to begin is to consider just four general asset classes you need to spread your wealth among to keep you financially balanced and healthy...

Note that each of those asset classes has a range of what percentage of your portfolio you should put in it, rather than a specific number. That's because everyone's situation is different. If you're in your 30s or 40s, your asset allocation should be different from if you're retired. That's because you have the ability to take more risks with your portfolio.

So you need to determine how risky a portfolio you can stand, and what your time frame for investing is. Then you can set your percentages accordingly... and stick to them.

Rule No. 5 – Stick to Your Position Sizing

One of the biggest mistakes novice investors make is ignoring proper position sizing. When I say position sizing, I mean how much of your portfolio you put into each investment.

For Income Intelligence, we recommend limiting each position to no more than 4%-5% of your entire portfolio. If your portfolio is $100,000, you should invest no more than $5,000 in a single investment.

It's easy to get excited about an investment that someone says could double your money in the next 12 months. And it's easier to manage a portfolio of two investments than it is to manage one with 20.

But the reality is, position sizing is the easiest way to protect yourself from a catastrophic loss. That leads us into our last rule...

Rule No. 6 – Define Your Exit Strategy on Day One

Our investing philosophy at Income Intelligence is based on safety. We designed this newsletter with the goal of recommending only the investments I would recommend to my own mother.

That said, every investment comes with risk. So you always need an exit strategy in place. When you write down your reasons for buying an investment, you should also take the time to write down your plan for selling it (one of our top mental tricks).

Your exit strategy can be to sell in exactly one year... or when the Fed raises interest rates... or anything. But you must have a strategy in place before you buy.

In Income Intelligence, we'll typically use a 20% hard stop as our exit strategy. By this, I mean that you set a stop loss 20% lower than your entry price.

For example, if we bought shares of a company at $50, your 20% hard stop would be $40. If the stock closes the day below that level, you sell the position the very next day. End of story.

This strategy allows you to let your winners run, while giving you enough breathing room to deal with typical market movements.

Here's to our health, wealth, and a great retirement,

Dr. David Eifrig