New York -- If you're an income investor today, you're having a hard time. Everywhere you turn, capital seems to be earning less. One-year certificates of deposit offer an average of 5.7 percent interest, according to the Bank Rate Monitor. Money-market mutual funds are averaging 5.1 percent, down from 9 percent just two short years ago.
At these rates, your money will never accomplish its primary function, which, in the words of Joe Louis, is to quiet the nerves.
A 6 percent rate of return, minus one-third for taxes and adjusted for 3.5 percent inflation, leaves you a real investment return of one half of 1 percent. So your purchasing power is going nowhere. Even an 8 percent yield from, say, Treasury securities leaves you with less than 2 percent real return, after taxes and inflation.
Caught in this bind, the typical investor performs the celebrated interest-rate shuffle -- switching to fixed-income investments that offer ever-higher yields. But super-high-rate investments carry greater risks, which your stockbroker or financial planner may not explain to you. The plain fact is that interest-rate investments won't cut it today. You need a better theory of income investing, which boils down to this: To increase your income over time, you also have to be buying stocks. And the right way to buy them is through the vehicle of stock-owning mutual funds.
To buy stock funds, however, means redefining what you mean by "income."
To most investors, income means only interest and dividends. But if income means "earnings," you also get it from the capital gains you earn on stocks. Not one of the financial planners consulted for this column put their income-oriented clients -- including retirees -- entirely into fixed-income investments. They picked stocks for 30 percent to 60 percent of their assets.
You may think that stock-owning mutual funds are too risky for your safe money.
"But a bigger risk," says Robert Preston, a retirement consultant and actuary in Danbury, Conn., "is having too much in fixed-income investments because of inflation and the way that interest rates fly around."
According to Ibbotson Associates in Chicago, stocks have yielded an average annual return of 6.7 percent above the inflation rate since 1926, compared with 1.4 percent for long-term U.S. bonds and only 0.5 percent for Treasury bills. After taxes, the bonds and the bills have fallen way behind.
Stock-owning mutual funds make it easy to get income from your investments. You reinvest all your dividends and capital gains and use the fund's systematic withdrawal plan.
A withdrawal plan pays you a regular check, usually monthly, of whatever size you need. Your remaining money stays invested in the fund. Even if the market declines in the months ahead, your capital should -- over several years -- increase by more than you withdraw.
As an example, take Neuberger & Berman's Partners Fund (800-877-9700) and assume a $100,000 investment. Assume further that, over the past 10 years, you withdrew an income of $10,000 a year.
Even after those withdrawals, your fund would have grown to $195,938! You'd have had your steady income without sacrificing capital gains. What's more, you could have increased your withdrawals by the amount of inflation every year and still wound up with more capital than you started with.
Growth of capital is important not only for young savers but also for younger retirees. Remember, at age 60 you may live another 30 years. If the purchasing power of your nest egg doesn't increase over the first 15 years of your retirement, you'll be eaten up by inflation in the last 15 years.
If you want to divide your money between stocks and bonds, consider "balanced mutual funds" that invest in both. Since the late 1970s, this group has had only one losing year, says John Rekenthaler of Morningstar in Chicago. Rekenthaler's picks: the balanced funds from Dodge & Cox (415-981-1710), Fidelity (800-544-8888), Vanguard's Wellington (800-662-7447) and Pax World (603-431-8022). Pax World specializes in "socially responsible" investing -- such as stocks in companies that don't pollute.