One way to understand the DIY Income Investor approach is to think of the different types of potential income as an 'Income Pyramid' - that is, layers of different sources of income, all built on a sound foundation and increasing in complexity (and hopefully in after-tax returns).
I'll go through these income layers 'from the ground up'. At all levels you should be considering ways to protect your income and investment from the Taxman (more about that below).
Level 1) A Sound Foundation
First, you shouldn't really consider significant savings or investment if you have debts. This isn't an area that I will try to cover here but there are many excellent Internet resources - for example here (UK). A key element is to live well within your means.
If you are paying off a mortgage, fine - learn to be a DIY Income Investor on a small scale, but aim to pay off your mortgage as quickly as you can!
Second, you will clearly need some money to invest. This could be by reallocating existing savings or by regular saving. The DIY Income Investor approach is a 'get rich slow' strategy and it will take time to build up your wealth. You may need to spend some time getting this stage right, as there is not much point going further until you have either net, surplus income to invest or existing savings that could be better invested.
Level 2) 'Easy Access' Savings
The first layer of savings should be an 'easy access' bank account. You probably have something like this already - a high-street current/checking account, for example. However, if you are regularly overdrawn - go back to Level 1!
Your 'easy access' savings should be on-line (i.e. one or more Internet accounts). The easy management of the DIY Income Investor strategy is helped by having your investments on-line, as far as possible.
How much you keep in 'easy access' accounts will depend on your expenditure levels and degree of caution: let's say 3 to 6 months' expenditure.
Even though it is the first layer of investment, you must focus on the rate of return, as the DIY Income Investor strategy is all about optimising the rate of return of your investments.
So, what is the average balance on your current account and how much interest are you earning? Is the interest you are receiving today as much as you could possibly get? (Hint: in the UK you can currently get nearly 3% on up to £5000 from a High Street bank.)
Level 3) Fixed-Rate Savings Accounts: Savings 'bonds' (UK) or CDs/Certificates of Deposit (US)
Once you have a sufficient 'buffer' of 'easy access' savings you can consider the possibility of fixed-rate savings bonds, which tie up your money for a period of time (sometimes several years) in return for a guaranteed rate of interest (which - obviously - should be higher than you can get for 'easy access' savings). You might consider a number of these accounts, committing your money over different time periods.
Level 4) Exchange Traded Funds (ETFs)
ETFs are the most cost-effective and least risky way of investing in shares, government bonds/gilts and corporate bonds.
Many investors - those who do not want to spend a lot of time with their investments - can stop at Level 4. A portfolio of cash plus ETFs, shielded from the Taxman, is all you really need.
However, if investing interests you, and you are willing to put in some additional work, the next levels may be rewarding.
Level 5) Government Bonds/Gilts/'Muni' Bonds
With increasing investing experience (and growing funds) you may want to try investing directly in specific government (or in the US, municipal bonds). This carries more risk than investing through an ETF (e.g. default risk) - but also potentially more reward, in the form of higher after-tax yields.
Level 6) High-Yield Dividend Shares
Investing directly in companies paying good (and hopefully regular) dividends is a way to grow both income and capital. It is also more risky than buying an ETF (which is diversified).
However, this is an interesting investment area, if you have the inclination.
Level 7) Corporate Bonds
Buying corporate bonds or other forms of fixed-income corporate debt directly is more risky than buying a diversified holding through an ETF. However, there are times in the economic cycle when you can 'lock in' some very attractive rates of return.
Shield your Income (and Capital Gains) from Tax
At all levels of investment you need to protect your growing income from the government's Taxman. This will obviously differ on your location.
In the UK the main tax-sheltering vehicles are:
- ISA (Individual Savings Account) - preferably the Self-Select Stocks & Shares variety
- SIPP (Self-Invested Pension Plan)
- Company pension plan (not really DIY - but see below)
In the UK, if you are building up your wealth (and you are a taxpayer) you might consider a Cash ISA temporarily while you are building up your savings, which you can convert to the much more flexible Stock & Shares ISA at a later date.
A SIPP is similar in operation to a Stocks & Shares ISA but with withdrawals allowed only after you have reached a minimum retirement age.
I;ve included a company pension plan in the list. Although it is not DIY, it may be a good tax-efficient way to build up your wealth and future income. In many cases the company will contribute to your pension fund and allow some flexibility in how your pension is invested.
Tax-shielding accounts in the US include:
- municipal and other government bonds
- IRA or Roth IRA
- 401(k) retirement account
Later posts will talk in more detail about all of these layers of income investment how to minimise risks and how to blend the layers of income investment to a mix that you are comfortable with.
I am not a financial adviser and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.