Many investors and retirees rely on their investment portfolio to fund all, or part of their cash needs. In wealth management, there are two practices employed to create this cash flow; the income approach and the total return approach.
The “Income Approach” requires buying securities that provide dividends and interest and not touching their principal investment. In this current low-yield environment, the hunt is always about finding securities with higher yields to fund their cash flow needs. If yields are high enough or the portfolio value is large enough, investors may be able to live off dividends and interest without having to dip into principal.
The “Total Return Approach” involves trimming positions in the portfolio on a systematic basis to create cash flow. If you are a client who is drawing income from your portfolio that we manage, you are very familiar with this technique because it is the method we utilize to create your cash flow. It is an approach based on the fact that there is little difference whether cash flow comes from dividends or capital gains. This method inherently affords greater control over the amount of cash flow generated because it is not dependent on how returns are divided between capital gains and dividends.
Traditionally, investors have employed the income approach. These investors often don’t realize the unintended risk they take on because there are investment tradeoffs required to pursue this strategy. Let’s explore some of the classic misconceptions of the income approach.
High dividend paying stocks are less risky: This concept comes from the long-held belief that these stocks have less risk because they offer a regular stream of cash payments to shareholders. However, because these dividends come directly from company earnings, the company’s stock price is reduced by the amount of the dividend. And, dividends can be cut or eliminated altogether as we saw in the market meltdown of 2008-2009.
Living on high dividend paying stock avoids invading portfolio principal: Unless a dividend is reinvested back into the portfolio, the portfolio is diminished as the stock price generally declines by the amount of the dividend. Although the stock is not sold, the economic impact is the same.
High dividend stocks offer downside protection: The thought here is that paying dividends somehow protects the falling price of a stock. For example, a stock paying a 3% dividend might provide an equal amount of price support. But, since a dividend reduces a stock price by the same amount, the price would have actually dropped less for a stock paying no dividend.
As I mentioned, the income approach carries more risk due to inherent tradeoffs that strategy requires. Some of those tradeoffs include:
Less diversification = higher risk: Obviously, investing in a portfolio that is dominated by high income paying stocks is less diversified than one that isn’t. In 2008, for example, high dividend paying bank stocks were decimated.
Putting the focus on high dividend-paying stocks reduces choices: If dividend-paying stocks are the focus of a strategy, then roughly 40% of all stocks globally cannot be considered as they pay no dividends. This, too, lowers diversification because the bigger the palette to choose from, the better the quality of choices. Additionally, the number of stocks paying any dividends at all is decreasing globally, from 71% of the market in 1991 to 61% in 2012 (Source: Dimensional Fund Advisors).
Focusing on high dividend-paying stocks may hurt returns: Global portfolios that hold only dividend-paying stocks must exclude 47% of the available small-cap stock universe as small-caps traditionally don’t pay dividends, but do have higher expected returns than large-cap stocks.
Dividends are not guaranteed: Nothing more need be said about this tradeoff.
The total return approach allows greater control over the amount and timing of cash flows and maintains a more diversified (less volatile) portfolio. For taxable accounts, this method also has significant tax advantages over an Income/dividend model because it also utilizes lower-taxed capital gains as an important component of the cash flow stream.
- An Income Strategy that concentrates solely on interest and dividend income reduces diversification, limits investment choices, diminishes flexibility, inhibits the ability to manage taxes and lowers expected returns.
- Retirement accounts at Financial Synergies utilize a Total Return methodology to produce an income stream in a well-diversified portfolio geared to grow in value while it produces cash for our clients to live on. We call it Retirement Salary® and you can learn more about the specifics of it on our website.