Reducing your income risk is crucial when investing

When investing and managing your money, you must consider and deal with a number of potential risks. These include general market moves, individual company, interest rate, inflation, default, political, currency, liquidity, volatility and others.

Some of these are more important at different times in one’s life. If you are relying on your investments to provide income to pay your expenses, you are rightfully concerned about the stability of income. How concerned you are depends on whether this income is needed to cover basic expenses or is used for discretionary purposes.

Regardless of how you use the income, let’s look at how you can manage these risks and improve the reliability of your overall investment income.

Income needed to cover your basic expenses such as housing, food, clothing, insurance, utilities, transportation and healthcare should come from reliable, steady sources. Preferably sources such as Social Security or government benefits, and pensions. If these sources do not cover your basic expenses and you need to create income from your savings, there are several options.

The first is to create income similar to a pension using an annuity with a guaranteed payout. The type of annuity you use depends on when you want to start payments, the amount of income you need compared to the savings available, and the interest rate and inflation environment.

If your savings will allow you to buy an annuity that will provide the income you need, from a high-quality company, this often is the most secure way to go. This does not mean investing all your savings in an annuity because you need to have some liquid reserves available for unknown events. You can also use CDs and other insured accounts to generate income, although the returns are small.

Beyond insured products, we are concerned about how reliable the income will be from an investment. One way to deal with potentially varying income returns is to maintain a large enough cash reserve so you can pay for normal expenses and let the cash balance float up and down. This works well if you own stocks, bonds or similar investments that pay out quarterly or semi-annually.

If the payments are not reliable, you will need a larger cash balance to cover the larger potential swings. You should choose high-quality investments that have a history of consistent payments when using this technique. Understand where the returns are coming from and if they are adequate to support the payments.

How much of the income is being used to support the payments to investors?

Is there enough left to continue running the business?

With stocks, real estate investment trusts (REITs) or partnerships, you can look at distribution or dividend payout ratios. With bonds, the starting point can be the credit ratings. Although a more in-depth look is needed to understand what is behind the ratings.

Diversification of income streams is another tool for reducing risk. By using various investments such as stocks, REITs, pipeline partnerships, bonds and diversifying over different industries, geography and size, you can lower your risk from any one investment.

This is the same principle used when investing for growth except you are looking to diversify income return rather than total return. Consider using preferred stocks and bonds for reliable payments even though the ability to grow income is limited. Common stocks that pay dividends that are growing will help keep up with rising living costs.

REITs and Master Limited Partnerships, often in the energy industry, can have higher payments due to their corporate structure that avoid a level of taxation. However, they are tied to more volatile industries. Closed-end mutual funds can use leverage and manage their distributions to maintain a higher, steady income to investors.

If your investment income is used for discretionary expenses, you can take on investments with somewhat higher credit or financial risk as you will less impacted if they do not perform as expected. The key is to match the investment to your specific need. For basic expenses, a guaranteed product is a better fit than a potentially higher returning, but volatile, investment. No matter how the income is being used, you can reduce individual company, country, industry and other risks by diversifying.

This story was originally published February 13, 2017 at 1:03 PM with the headline "Reducing your income risk is crucial when investing."