- September 11, 2018
- Mike
We’re sometimes asked by potential clients, looking to generate income in retirement, if we will construct for them an “income portfolio,” enabling them to live off the dividends and interest without dipping into principal. It’s completely understandable why this question arises, as this is one of the most pervasive and insidious myths in the investing world. By myth, I simply mean that we believe the traditional definition of the income portfolio is based on an unfounded and false belief.
I should note that we are certainly not unique in our belief that the traditional income portfolio is faulty. There are countless academic studies and years of practical application that support this viewpoint. Most wealth managers abandoned this income approach years ago.
The Basic Problem With The “Myth”
An income portfolio is fixed by design – usually an inappropriate design. A strict income policy enforces an unnecessary constraint on the portfolio construction, which almost always leads to an inferior portfolio. Even worse, it can lead to a portfolio that is not only inefficient, but one that will fail to accomplish the client’s long-term financial goals.
An investment’s return is comprised of two components: Income (dividends and interest) and Capital Gains.
Total Return = Income + Capital Gains
Having an income portfolio does not increase total return. It simply decreases the amount of return delivered in the form of capital gains. Focusing solely on the income portion is an artificial constraint on the type of eligible investments for the portfolio and limits the ability to fully diversify.
We take a total return approach to portfolio construction, even if the client is retired and in withdrawal mode. This is the linchpin to our Retirement Salary® program. With this approach, it is of little importance whether the return comes from income or capital gains.
Fixed Income Math Can Be Cruel
The crux of the traditional income portfolio is the belief that it must be constructed only with securities that produce significant income: bonds and dividend-paying stocks. No attention is paid to the capital gain potential, which could be a huge component of an investment portfolio.
Most investors will purchase a bond based on the income it will produce, usually not paying much attention to interest rate risk. The general thought process being, if you just hold the bond to maturity you’ll receive all the interest payments and the original principal put in. Technically, this may be true. But this may be more illusion than fact.
There is an inverse relationship between interest rates and bond prices. When rates fall, bond prices increase. When rates rise, bond prices fall. This can be especially cruel for income-oriented investors because they can interpret rising rates as a good thing for their portfolio. In reality, their bonds are declining in value along with their net worth. So, does holding the bond to maturity eliminate this risk?
Let’s say an investor buys a one-year corporate bond at a $1,000 face value that pays a 3% interest rate at the end of the year. He expects to get back $1,030 in a year. His bond is worth $1,000 today because the market pegs the 3% rate as fair for this type of bond. The math behind it goes like this: $1,030/1.03 = $1,000.
After he buys the bond there is an increase in market rates. Suddenly, investors want a 4% yield on this type of bond. The bond is now worth only $990.38 ($1,030/1.04), having declined by $9.62. Still, this investor may take comfort in not having lost a dime as he is still going to get the $1,030 back at maturity.
But unfortunately, he is going to receive only $30 interest when the market now demands $40 interest for this type of bond. This translates to receiving $10 less in one year, based on the current 4% return expectation. The investor is immediately out $10.00/1.04, which is exactly equal to the $9.62 decline in value of the bond. This is not merely a coincidence. The math always works out the same irrespective of the interest rate or the maturity of the bond.
Simply put, if interest rates increase, there is a decline in the value of the fixed-interest payments and the return of principal. Holding the bond until maturity does nothing to protect the investor from increasing interest rates. The investor receives less money than the current market would dictate.
Dividend-Paying Stocks Are No Panacea For Income Investors
Unfortunately, the math for dividend-paying stocks can be equally frustrating. All too often investors will look to the “dividend yield” of a stock to determine if it’s worth owning in an income portfolio.
Dividend yield is simply a financial ratio that measures how much a company pays out in dividends each year relative to its share price. It’s calculated by dividing the dollar amount of dividends paid (per share of stock) throughout the year by the dollar value of one share of stock:
Dividend Yield = Annual Dividends Per Share / Price Per Share
There’s nothing magical about a company that pays dividends. And the dividend yield can be very deceiving for investors who are only concerned with “high yielding” stocks. One danger of just focusing on dividend yield (one that we see all too often) is that the current yield is directly related to the stock’s price. If the stock’s price drops, the dividend yield increases. If the stock’s price goes up, the dividend yield decreases.
For example, let’s say you are looking for dividend-paying stocks that yield at least 4%. ABC stock is trading at $100/share and has paid $3.00 in annual dividends. The dividend yield is 3% ($3 / $100 = 0.03). So, this stock is not on your radar just yet. Then ABC’s stock price drops to $75/share, bringing the dividend yield to 4% ($3 / $75 = 0.04). Now this stock is attractive to you because of the 4% dividend yield.
ABC’s stock price dropped from $100 to $75, losing 25% of its value. And subsequently the dividend yield went from 3% to 4%. Is this a good reason to buy the stock? The answer is, it depends on many other factors. Obviously something pretty dramatic has occurred for the stock to drop 25%. I’m not sure an income-oriented investor wants anything to do with that type of volatility. This could spell trouble for the company in the short and long term. Eventually, it could lead to the company slashing its dividend or cutting it altogether. This would be disastrous for the income investor. Just ask GE shareholders.
The other thing to consider is that when a company pays a dividend to shareholders, the leaders of that company are making a decision to distribute company profits to shareholders in lieu of reinvesting that cash back into the company for future growth (capital gains). There is an opportunity cost to this decision. As they say, there is no free lunch.
I should probably pause here and make something clear, because I know it sounds as though I’m bashing bonds and dividend-paying stocks. We utilize bond funds and dividend-paying stocks (mutual funds / ETFs) in all of our portfolios. They are an essential part of our investment strategy. I’m just trying to illustrate that constructing a portfolio, with only the income characteristics of the securities in mind, is forgoing an entire component of the portfolio’s return potential – capital gains.
We focus on the total return of the portfolio. It does not matter where that return comes from.
Conclusion
When constructing a portfolio to provide income for a lifetime, it’s important to look beyond the paradigm of dividends and interest. Focus instead on total real return. Without the constraint of the “myth,” it is possible to balance the need for real cash flow with the need for long-term growth.
