Retirees can take two main approaches to spending from portfolios. The first is to focus on income and dividends produced in the portfolio, a.k.a. “income investing.” The second is to sell assets as appropriate to meet spending needs. From your portfolio’s point of view, they’re basically the same thing. There is no economic difference between the two approaches. But, from your point of view, you should be aware of one difference: focusing on income investing can make your portfolio less diversified.
Income Investing
Income investing, at least in this context, is when you focus on generating the income you’ll need from interest and dividends in your account. Many folks feel safer going this route because they feel it avoids “eating your principle” since they’re not selling off shares.
Total Return Investing
Total return investing is predicated on the idea that money in your investment accounts is fungible. It doesn’t matter whether you use money from dividend or interest income or selling securities. This allows you to focus on putting together the best portfolio and not worry about the yield coming from your portfolio.
With Income Investing, You’re Giving Up Control of Your Income
If you build your equity portfolio around generating dividends, you give up control of how much you are going to spend. While dividend rates are historically less volatile than capital gains, they still move with the broad economy, especially when times are bad. You are at the mercy of your portfolio company’s boards of directors. If your portfolio distributes fewer dividends this quarter, you’ll be spending less next quarter.
With Income Investing, You’re Still Eating Your Principal
One of the big draws to income investing is that it seems safer because you don’t touch the principle. You always have the same number of shares. But if you think about what a stock is – a tiny sliver of ownership in a company and all future cash flows – you realize how deceptive this thinking is. As dividends are distributed, the share price of the stock declines.
For example, if the expected future cash flows from a company (in other words the share price of the company) were $100, and then it distributed a $5 dividend, the share price would fall to $95, after you control for market movements. The company no longer has that $5, since it distributed it to the shareholders. You just got that part of the expected future cash flow. In other words, whether you are meeting your spending needs from income investing or total return investing, it’s an exercise in semantics – the money is coming from the same place.
Diversification is Your Friend
Since income investing and total return investing generate income from the same place, where is the difference? Portfolio construction and diversification.
Income investing forces you to build your portfolio around stocks that pay dividends. That’s fine, except those stocks are different than the market as a whole.
According to a study by Stanley Black at Dimensional Fund Advisors, a significant portion of companies around the world simply don’t pay dividends. In 2012, only 61% of companies actually paid a dividend, down from 71% in 1991. That means almost 40% of the companies around the world are going to be left out of your portfolio[1] or, at best, significantly underweighted. That would be tolerable if those companies were randomly distributed and looked like any other company around the world, but that’s not the case.
Not only does the proportion of dividend-paying companies vary by country (in 2012, 92% of Japanese companies paid dividends, compared to 38% of Australian stocks), but the average dividend payout ratios for those companies is all over the map, as well. This means you won’t get a true representation of different markets across the world.
There are similarities between types of companies that choose to distribute dividends and those that don’t. Dividend-paying stocks tend to be larger companies. In fact, about 47% of the small cap companies around the world did not pay dividends in 2012. This can have a significant impact on your portfolio’s expected return and, as a result, your ability to meet your spending needs through retirement, as small cap stocks have higher expected returns.
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.
To find out more about how to build an investment portfolio that works for you, read our eBook 9 Principles of Intelligent Investors.
[1] Black, Stanley. March 2013. “Global Dividend-Paying Stock: A Recent History.” Dimensional Fund Advisors white paper.
