Everyone has their doubts about money and investing. Some people want instant gratification (income) from their investments, while others are fine with a delayed but higher gratification (wealth).
Investing for income or wealth is one of the most pressing questions one faces while investing. While building wealth is a common objective for people who start investing at a young age, people in later life (mostly retirement) generally seek income from an investment to support their living expenses.
Let’s understand how both these modes of investing work.
How it works
Income investment can supplement your other sources of income and gives you more disposable cash to spend. In contrast, investments for wealth can give you a large corpus later in life that can help you fund more significant decisions like buying a home, paying college tuition, or retirement.
In investing for income, your underlying base of investment has to be high enough to generate a meaningful profit. For example, a 5% annual return on a $10,000 will return a meager $500 in income, which may not move the needle much if your annual spending budget is $30,000. However, it will make a massive difference if your investment base is $1 million that gives you $50,000 in income.
Income investments also tend to be conservative investments because the near-term safety of capital is of utmost importance to keep a sustainable amount of cash flowing.
When investing in building wealth, you have a long-term goal, which allows you to be a little aggressive with your investments, helping you make higher returns. Therefore, even smaller amounts, when contributed for an extended period, build a massive corpus in the future.
For example, investing $500 a month, which earns a compounded 10% per annum, can make more than a million-dollar in corpus in 30 years.
The difference between investing for wealth and investing for income is pretty stark. This is because when you invest for wealth, you let your investment compound - earn returns on returns - while in investing for income, you take out your returns periodically, leaving only your capital to make returns.
The power of compounding
“Compound interest is the eighth wonder of the world. He who understands it, earns it... he who doesn’t... pays it.” ― Albert Einstein
The power of compounding makes a considerable difference to your financial condition, as the investing results can be wildly different when invested for simple returns (for income) and when invested for compounding returns (for wealth). Let’s have a look at the illustration below to understand it better.
In the above illustration, when the investment earns compounded returns, it results in 65% more in earnings than a simple return investment of the same amount with the same duration. The profits could have been even higher had the investments earned higher returns, which is generally the case with long-term compounding investments.
What’s the right kind of investing for you
For people in young ages with day jobs or small businesses, investing in wealth makes more sense as they have the time and propensity to take financial risks that have long-term payouts. The need to generate income from an investment is less when your day job or business income sustains your spending needs.
Income investments are right for you if you have already accumulated a good corpus and rely on your investment base to support your living expenses. This is mainly when you are retired and no longer have the regular cash inflow from your day job or business.
Investing for wealth is a phase that generally comes before the investing for income phase in your investment journey. In the first phase, you aggressively build your corpus to reach a target base, which can then be put to work to earn investment income in the second phase.
The final word
It is in the best interest of a smart investor to take advantage of compounded returns when you have enough time and risk-taking capacity. There are real-world examples of people investing as high as 80% of their income in wealth, building moderately risky investments like index funds and retiring in their early 30s with a million dollar in investment base. This base can be used by the investor to generate income for a lifetime. That is how you can also use both these modes of investments to your advantage.