One often hears, “I am conservative, I only withdraw income and never touch principal.” It may surprise you though, that whatever your personal investment goals, this approach is not the best strategy to achieve those goals.
Rather, a yield- oriented investment and spending strategy leads to one of two undesirable consequences: (1) you set a spending target that is lower than you can afford, thereby depriving yourself of certain comforts and pleasures that you deserve, or (2) you end up with less purchasing power in later years, thus reducing your flexibility for spending, gifting to heirs, or supporting favorite charities.
These unfavorable outcomes occur because a yield-oriented strategy fails to create a properly diversified, tax-efficient portfolio that will have the highest likelihood of meeting your cash flow needs over time.
Let’s first review some of the key problems of an income-oriented strategy and then introduce a better approach, commonly called the “total return” strategy.
INCOME FOCUS CAN LEAD TO A RISKIER PORTFOLIO
Remember that optimal portfolios are well diversified across various sources of returns and risks, and that financial markets price risk in total return terms. A portfolio focused primarily on one component (say, just income) will fail to optimize the risk and return.
With an income generating focus, you might overweight your portfolio with high-yield (i.e. low quality) bonds and high dividend stocks in aging industries, while overlooking sectors with higher return prospects such as technology and emerging markets.
History reveals many examples of assets promoted as providing high income but proved to be very risky: low quality “junk” bonds, high-yield closed-end funds, subprime mortgage securities, auction rate preferred stocks.
WITHDRAWING THE CURRENT YIELD WILL NOT PRESERVE PURCHASING POWER
Some refer to U.S. Treasuries as “risk free.” Though they may be free of default risk, they carry considerable inflation risk.
For example, if you purchase a 20-year U.S. Treasury bond today and live off the interest payments, you are merely trading current risk for future risk. In twenty years, after inflation, the bond is likely to be worth only about half of its value today.
HIGH YIELDING INVESTMENTS MAY NOT BE GREAT LONG-TERM INVESTMENTS
Bonds may have high interest payments, but they offer no opportunity for growth in their value on redemption.
Stocks of companies that pay high dividends to their shareholders may do so because they have few interesting investment opportunities and little growth. Attractive dividend levels today may not be sustained over time as the company’s prospects dim.
FOCUSING ON INCOME MAY LEAD TO PAYING UNNECESSARY TAXES
The tax rate for interest income is substantially higher than the rate on capital gains. Stocks that generate capital gains can provide far more efficient cash flow than income from bonds.
In the “total return” approach, fundamental principles of finance (asset allocation and diversification) are applied to design a portfolio that properly balances risks and expected returns from a broad array of asset classes to match your lifetime financial goals. After-tax cash flows from interest, dividends, capital gains, and sales of securities can be applied to meet current cash needs, while any excess can be reinvested for future portfolio growth.
In summary, it is easy to confuse “I need my portfolio to support my spending needs” (a goal), “I am conservative” (a risk tolerance), and “I need income producing investments” (an implementation approach).
In developing your investment approach, an orderly sequence is important. Define your goals first, then develop a plan that balances these with risks. A “total return” approach to portfolio design will improve the likelihood that your portfolio will be support your withdrawal needs over time.