Have Your Cake and Eat It Too The Gift of Total Return Investing
A Better Approach to Retirement Income
Image Credit: iStock
One of the most frequent requests I often hear from prospective clients approaching retirement is wanting to have a portfolio that is full of dividend-producing stocks so that they can live off the dividend income and never have to sell anything.
And as great as this may sound in theory, it does pose several significant risks and may not be realistic for most investors.
Whether it’s the risk of chasing returns from interest and dividends or focusing purely on yield, it’s important to be aware of these risks and find solutions to alleviate them.
Thinking too narrowly when it comes to generating portfolio income could severely limit the quality of your retirement.
In today’s post, I want to challenge you to think more broadly and introduce the concept of building a portfolio that can provide income, growth potential, and liquidity.
What is Total Return Investing?
Total return investing is a strategy that takes a more comprehensive approach by considering all sources of returns, including market appreciation, dividends, and interest.
Think of this strategy as BOTH AND.
Total return incorporates both an investment strategy and an income plan that is focused on maximizing the overall return of a portfolio.
Image Credit: Vanguard
Most people fall into one of two categories when it comes to investing:
Traditional investing mainly concentrates on investment return, exclusively through capital gains and market appreciation.
Income Approach - Building a portfolio that generates enough income through dividends or bond yields to live on and never has to worry about selling any of your assets.
Total return investing instead takes a more comprehensive view by considering all sources of returns, including market appreciation, dividends, and interest, while also factoring in your appropriate level of investment risk.
Why Chasing Yields or Performance
Just Doesn't Work
As simple as it sounds in theory, relying solely on dividend and interest income is akin to putting all of your eggs in one basket and can be more trouble than it’s worth for several reasons:
Investment Risk: Though oriented differently than growth stocks, dividend stocks are not bonds, so the value of these assets is highly correlated with the stock market. This means a major market meltdown could put your entire retirement in jeopardy.
Lack of diversification: Being too singularly focused on portfolio income puts your portfolio at risk of being disproportionately invested in one asset class and paradoxically exposes it to more investment risk.
Changing investment environments: The only thing that is constant is change, which is why it’s so crucial to have a portfolio diverse enough to keep up with the times and weather whatever storm comes its way.
Colleen Jaconetti, a Senior Investment Analyst at Vanguard summarized several of these risks by saying,
"By reaching for yield, investors trade higher current income for a greater risk to future income. Investing too much in such volatile assets could mean that in a down year, you'd end up having to tap the principal you were trying so hard to preserve."
Teamwork Within Your Portfolio:
Each Asset Class Plays a Role
A standard, well-diversified retirement portfolio consists of three main asset classes: Stocks, bonds, and cash investments.
And each of these asset classes plays a unique and significant role.
Stocks can help deliver portfolio accumulation and growth over the long term and also pay out dividends.
Bonds can generate consistent income through fixed coupon payments which help stabilize a portfolio during a stock market downturn.
Not to mention, in today’s high-interest rate environment, higher coupon payments from bonds now translate into more money in your pocket as a bondholder.
Cash, High Yield Savings, and CDs - Much like the above comment, in today’s high-interest rate environment, your cash now goes further in providing you with a higher level of income as well as much-needed liquidity and flexibility for withdrawals.
💡IMPORTANT REMINDER: How you decide to allocate your retirement portfolio across these classes will depend on you and your unique financial goals.
Remember: We take risk where it is appropriate to take risk and we do not take risk where it's not.
Your portfolio should be structured with built-in flexibility to be able to provide you with income when you need it, as well as growth for the long term.
Benefits of Total Return Investing?
When combined with a flexible spending approach like the “Guardrails Method” I wrote about, a total-return investing strategy has several significant advantages when compared to the income approach:
Portfolio diversification - Total-return strategies tend to be much more diversified across multiple asset classes than traditional income approach portfolios.
This gives investors the unique advantage of having a portfolio that is less volatile during a market downturn but also flexible and liquid enough to decide which source to pull from to meet income needs.
Tax efficiency - Total-return investments may pay less in taxes compared to those who only receive dividends or bond interest.
Why? Distributions (if flexible enough) can come from the growth of your portfolio which is taxed at capital gains rates and is lower than ordinary income tax rates.
Lower overall risk - Because of the power of diversification and utilizing a wide range of varying asset classes, investors can reduce the overall amount of risk they expose themselves to.
Rather than being outcome-focused like many Income Strategies fall victim to, a total return strategy uses an investor’s goals and risk tolerance to guide allocations instead.
As a result, total return investors are able to meet their investment objectives while maintaining a stable portfolio.
More control and flexibility of portfolio withdrawals -
In addition to having more control of distributions with respect to taxes, total return investors also have the flexibility of determining which asset class to pull distributions from which can extend the longevity of a portfolio.
For example: Keeping one to three years of living expenses in cash and other short-term investments could provide investors the flexibility to allow for markets to recover during a bear market and pull distributions from cash rather than sell their stocks in a down market.
Summary
Like with anything in life, balance and moderation are good things.
When it comes to your retirement, minimizing your portfolio risks and maintaining portfolio longevity is crucial.
Total return investing is an approach that enhances the probability of an investor meeting their spending goals through a combination of portfolio income and capital appreciation.
Dr. Wade Pfau said it best and I'll close with this:
“In short, focusing on dividends and income produced by your portfolio just doesn’t make any sense. Not only is it essentially the same thing as total return investing, but it can hurt your portfolio.
You need to focus on the things that are actually under your control. Focus on taking the right types of risk and diversifying as much as possible.
These things get you through retirement, not gimmicks like income investing.”
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