What Are Income Stocks, and How Do They Work?

Income stocks provide investors with regular dividends that can unlock a more comfortable retirement. Discover the pros and cons of these types of stocks.

by | Last updated 20 Mar, 2023 | Investing Strategies

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Income stocks are shares of businesses that pay reliable and recurring dividends. And for shareholders, this consistent redistribution of capital can establish a lucrative stream of passive income.

These types of investments typically don’t offer much in terms of growth. However, given sufficient time, annual dividend hikes can lead to impressive portfolio yields. And deploying a dividend investing strategy is how notable investors such as John Neff found success managing the Vanguard Windsor Fund for 31 years.

What is an income stock?

As previously mentioned, an income stock is any publically traded equity that pays dividends to shareholders. However, investors usually exclude companies that don’t have a reliable track record. After all, if the goal is to establish a consistent stream of passive income, owning shares in erratic businesses isn’t ideal.

As such, most income stocks are typically mature businesses with robust cash flow. This usually means reduced share price volatility, making them more attractive to conservative investors with lower risk tolerances. But, with maturity, growth is also usually more challenging. Therefore, investors are often left relying on dividends for investment returns rather than share price appreciation.

The importance of hardy cash flow can’t be understated. Don’t forget dividends are entirely optional payments for corporations. They exist as a method of returning excess capital to shareholders that the firm has no better use for. But if cash flow becomes disrupted, a firm may choose to cut, suspend, or cancel shareholder payouts to preserve internal resources. This is why all travel income stocks stopped paying dividends in the 2020 pandemic.

Related: How often are dividends paid?

Key characteristics

  • Mature Enterprise – Dividend stocks are usually found in mature enterprises. Consequently, the company choose to return excess cash to shareholders as there are few economically-viable expansion opportunities.
  • Lower Risk – As the companies have matured, cash flows are often more established and reliable. This translates into more consistent dividend payments with higher stability in the share price. Income stocks usually have a lower risk profile than growth stocks. But there are always some exceptions.
  • Lower growth – Mature businesses, many times, will have limited options available to expand operations and create shareholder value meaningfully. As a result, the stock price is usually exposed to lower levels of volatility. However, it also means share price appreciation is often lacklustre.

Advantages of income stocks

Every type of investment carries some element of risk. Having said that, income stocks are known for being more stable and predictable. And that can open the door to some decisive advantages.

  • Passive Income – A carefully constructed income portfolio can deliver a monthly passive income stream. And sufficient capital can pave the way to a more comfortable or even earlier retirement.
  • Rising Returns – Profitable companies with expanding cash flows may have a track record of increasing dividend payments yearly. For shareholders, this translates into a rising dividend yield on their original cost basis. And this enables their passive income stream to keep growing. This effect can also be amplified through automatic reinvestment.
  • Stability – While not always the case, the underlying business is mature, providing stability to the shareholder payout and the stock price.

Disadvantages of income stocks 

Like all types of financial securities, dividend stocks are not without disadvantages.

  • Dividends Not Guaranteed – Disruptions to cash flows reduce the amount of capital a company can organically fund. This can compromise shareholder dividends and, in turn, investor passive income.
  • Lower ROI – Since businesses pay excess profits to shareholders, fewer resources are available to allocate toward growth. This means investors are often relying on dividends alone to provide investment returns.
  • Interest Rate Risk – Increases in interest rates provide higher returns from newly issued bonds. It also causes the cost of capital to rise, negatively impacting share prices. Thus, reducing the value of an investment portfolio.
  • Inflation Risk – Some income stocks may not yield higher than inflation. For investors relying on dividends as an income stream, prolonged underperformance against inflation will destroy wealth.
  • Taxes – Unless using a tax-efficient investment account, dividend income is treated as taxable income even when automatically reinvested. This will harm the overall return on investment.

Top 10 US income stocks

The pinnacle of dividend stocks is dividend aristocrats. These are shares that have consistently delivered dividend increases for more than 25 years in a row.

The top US income stocks in terms of consecutive dividend hikes are:

Dividend AristocratIndustryDividend Increase Streak
American States Water (NYSE:AWR)Utilities68
Dover Corporation (NYSE:DOV)Industrials67
Northwest Natural Holding (NYSE:NWN)Utilities67
Genuine Parts (NYSE:GPC)Consumer Staples66
Procter & Gamble (NYSE:PG)Consumer Staples66
Parker Hannifin (NYSE:PH)Industrials66
Emerson Electric (NYSE:EMR)Industrials66
3M (NYSE:MMM)Industrials64
Cincinnati Financial (NASDAQ:CINF)Financials61
Johnson & Johnson (NYSE:JNJ)Healthcare60

Income stocks vs growth Stocks

Many different investing strategies are available, each with its advantages and disadvantages. However, focusing on growth stocks is arguably one of the most popular.

These businesses are typically younger, with immense long-term potential ahead of them. And for investors who successfully identify which companies will succeed, explosive returns can be achieved.

However, transforming into an industry titan isn’t exactly easy. Most growth stocks fail to meet investor expectations. And even temporary hiccups in operations can result in massive share price swings that conservative investors may not be comfortable with.

Income StockGrowth Stock
Company TypeMature, Established Enterprises.Young, Expanding Enterprises.
Return on InvestmentLow Capital Gain. High Dividend.High Capital Gain. Low Dividend.
DividendsStable Regular Dividend Payout.Low-To-No Dividend Payout.

Should I invest in income or growth stocks?

Before buying a stock, investors must verify that selected businesses align with their personal investment goals, risk tolerance, and investment time horizon.

Both income and growth stocks have their pros and cons. But deciding which approach is best ultimately depends on the individual circumstances of the investor.

A popular strategy is to build a portfolio that blends the income and growth strategies together. This can help to diversify the risks while enjoying the best of both approaches.

Other types of stocks

  • Value Stocks – Shares of companies trading below estimates of intrinsic value. Investors buy these underpriced shares and hold them until they begin to trade above fair value.
  • Defensive Stocks – Shares of companies that operate in defensive industries less susceptible to economic fluctuations. Defensive stocks have historically outperformed during bear markets but underperformed during bull markets.
  • ESG Stocks – Shares of businesses that seek to add value to society, the environment, and employees while generating positive returns for investors. ESG stocks are typically hunted by investors who want to build an investment portfolio that aligns with their personal morals and ethics.

The bottom line 

No single type of stock is, per se, superior. But It’s essential that investors build a strategy that reflects their investment goals, risk tolerance and time horizon. Income stocks can provide a lucrative stream of passive income. But for those capable and comfortable taking on more risk, exploring growth opportunities in the stock market could boost a portfolio’s return on investment.

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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.

Written By

Prosper Ambaka, Esq.

Prosper is a self-taught financial analyst and investor with years of experience. Inspired by Benjamin Graham, he employs a value-investing school of thought throughout his analyses. This has led to Prosper developing a wealth of knowledge in equities, foreign exchange, commodities, and global macroeconomic issues.

In 2019, he completed his Law degree and was called to the Nigerian Bar in 2021. Outside The Money Cog, Prosper encourages others to join the investment community through his lectures on financial literacy as well as investing strategies.

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Edited & Fact Checked By
Zaven Boyrazian MSc

Zaven has worked in several industries throughout his career, from aircraft factories to game development studios. He has been actively investing in the stock market for the better part of a decade, managing over $1 million across multiple portfolios.

Specializing in corporate valuation, Zaven employs a modern take on the principles set out by Benjamin Graham to find new opportunities at fair prices.

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