Key Takeaways
- Cash flowing assets such as stocks, bonds, real estate, and money and market funds generate regular income.
- Well-balanced investment portfolios usually include cash flowing assets alongside growth-oriented securities.
- Cash flowing assets can provide security and tend to be less volatile than growth-oriented assets.
Steady cash flow is critical to the functioning of any financial endeavor. Well, that should be rephrased. Positive steady cash flow is critical to the successful functioning of any financial endeavor. That’s why most well-balanced investment portfolios include income-generating assets along with growth-oriented securities.
Investors who focus specifically on cash flow are typically referred to as income investors. These people make it a point to include assets such as dividend-paying stocks, bonds, real estate, and other types of assets capable of generating cash on a recurring basis.
Cash Flow vs Capital Gains Investing
Capital gains investing tends to be somewhat speculative in nature. Investors purchase shares with an eye toward price increases to make their purchases more valuable. Then, at what feels to them like the most opportune moment, these investors will sell and either pocket their gains, or reinvest them in another equity they believe to have growth potential.
While the possibility for profit with this strategy is great, so too is the risk. Capital gains investments are highly susceptible to the ebbs and flows of the market. When times are great, these investors can reap significant benefits.
Meanwhile, cash flow investors look for assets capable of providing a consistent and predictable return at specific intervals. This could be monthly, quarterly, or even annually. The key traits of which to take note here are predictability and consistency.
Investors who purchase dividend-producing stocks could enjoy income for as long as they own that stock, and it continues to perform well. Similarly, real estate investors will derive income from their investment for as long as they own the property and maintain it in good condition.
In other words, the cash flow investor can usually buy and hold an asset with reasonable confidence that it will produce income. Focused as they are on long-term trends, they are largely freed of the need to closely monitor the market to decide whether to hold or sell a position. The short-term peaks and valleys of the market bear only peripheral significance to the activities of cash flow investors.
Types of Cash Flow
There are three basic types of cash flow.
These include:
Operating cash flow, which refers to returns derived from day-to-day buying and selling activities. Any successful retailer will tell you their profit is earned when they buy as opposed to when they sell. Purchasing raw materials at the lowest possible price helps ensure their profit potential.
As an example, consider the operations of an automobile manufacturer. They purchase parts and raw materials, assemble them into automobiles and sell them. They also have other costs, including labor, taxes and the like. The goal is to recoup these costs and earn a profit when the cars are sold.
Financing cash flow is related to the conducting of financing activities. Acquiring and repaying capital investments, whether equity or long-term debt, is a good example of this. Cash received from issuing stocks and bonds, or borrowing, is balanced against payments to satisfy debts, stock repurchases and bond payments. The difference between the two is the net cash flow from financing activities.
Investing cash flow is generated from activities related to investments. Generally, this results from the buying and selling of long-term assets such as property, facilities, and equipment. This can also include investments in assets that are considered intangible, such as equity and debt issued by other organizations. When these assets are sold, the funds generated are considered inflows, from which the total amount of the outflows is subtracted to arrive at the net investing cash flow.
Cash Flow Generating Assets
Investment-related assets falling under the heading of cash flowing include, dividend stocks, bonds, real estate, money market funds, certificates of deposit, money market accounts and annuities.
Dividend stocks are those issued by companies that make regular cash payments, the amounts of which are based upon the performance of the company.
Dividend stocks are usually classified as either common or preferred. Preferred stocks pay a consistent predetermined amount over a specific period. Their dividends are also paid before those of common stocks.
However, while preferred stocks represent guaranteed payments, common stocks hold the potential to pay more, because their amounts are not predetermined. On the other hand, there could be instances in which common stocks do not pay at all.
Bonds represent loans to companies and government entities, the income from which is derived in the form of fixed-interest payments. Bondholders are compensated on a regular schedule over a specific period. Their initial investment is returned when the bond goes to term (the loan period ends.)
Generally, there are three types of bonds, government (sometimes referred to as Treasury notes), municipal bonds and corporate bonds. The amount of income a bond returns is based upon its interest rate, term (the length of the loan), creditworthiness of the issuer and market conditions in general.
Real estate investments come in several different forms. In addition to buying properties and leasing or renting them to tenants, investors can participate in real estate investment trusts (REITs). Real estate syndication, also known as real estate limited partnerships (RELPs) also provides several of the benefits of owning properties without many of the concerns landlords face.
Income from real estate investments is derived from rent payments from directly owned properties. REIT and RELP investors receive dividends, the amounts of which vary according to the types of property. They also get a share of the profit when a property is sold.
Money market funds invest in dividend-paying short-term, low-risk debt securities. These low volatility investments can be either taxable or tax exempt. Operating on the net asset value standard, money market funds generate consistent dividend payments.
Certificates of deposit are basically savings accounts with fixed terms, the duration of which determines the income the depositor receives. The longer the term, the more the depositor is paid. Interest payments are sometimes distributed as they are earned, but the principal must remain on deposit for the duration of the term.
Money market accounts operate somewhat like certificates of deposit; however, they typically entail more restrictions and require a larger initial deposit. Withdrawals can be made up to six times monthly.
It should be noted that certificates of deposit and money market accounts operate more like savings accounts than investments. While they do offer a return and are reasonably liquid, their yields tend to be quite low. On the other hand, they are FDIC insured, so their risk factor is practically zero.
Annuities make regular payments to their holders for life. An initial investment is made and income is derived in periodic installments. This is known as annuitization. These products are typically offered by insurance companies and are usually presented in three varieties. Fixed annuities pay a pre-set interest rate. Variable annuities pay a floating interest rate, based upon the performance of the investments (typically mutual funds) they represent. Indexed annuities pay based upon the performance of a specific index, such as the S&P 500, in which they are invested.
Cash Flowing Assets and Portfolio Diversification
One of the primary goals of portfolio diversification is minimizing the effects of volatility. Diversified investments such as mutual funds and real estate investment trusts can spread an investor’s risk over a broader range of assets. The latter can also create cash flow. That is why many experts recommend diversifying an investment portfolio as much as possible.
To that end, alternative investments can also provide a strong opportunity for both diversification and income. In fact, one of the key benefits of incorporating alternative investments into a portfolio is the diversification they can afford. Lacking direct correlation to the markets in general can be an advantage for alternatives, particularly during periods of exceptional volatility.
