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My Portfolio’s Income Yield Is Next To Nothing…Should I Worry?

Timothy GroveAugust 19, 2016

Investments

There are few things in life more reassuring than a steady income.  In our working years, of course, that means a paycheck that arrives without fail at some regular interval. Whether it is an actual paper check we can touch, feel and bring to the bank or a direct deposit that gets added to our bank account balance, which we see printed in black and white, it provides constant comfort.  In our retirement years, that regular and reliable income will come from Social Security and/or, perhaps. a defined-benefit pension.  And, of course, that income can only take one form-good old cash!

But what about our investments?  Many investors, who want that same clockwork-like regular cash payout (along with something tangible such as a check or a direct deposit) from their investments, are drawn to bonds and dividend-paying stocks.  This choice has a very strong historical precedent.  Years ago, investing in bonds involved the actual mailing of physical coupons to the bond issuer and getting a check for the interest payment in the mail, while up until the 1980s or so most of the return from stocks was actually in the form of dividends and not capital appreciation. These dividends were paid by check and arrived in the mail.  Traditionally it was also a considered a very bad idea to use, or “invade” principal in a portfolio; only the income (again, in the form of dividends and interest) was to be relied upon.

This precedent is further illustrated in irrevocable trusts.  Irrevocable trusts have two sets of beneficiaries:  income, or current, beneficiaries, who are paid the income generated by the trust assets, and remainder beneficiaries, who receive the trust assets, or principal, at some point in the future.  The trustee (the one who has the responsibility of managing the trust assets) is faced with two conflicting tasks. His or her role is to generate as much income as possible for the current beneficiaries while growing the value of the principal for the remainder beneficiaries.

In the past, it was possible to have an investment strategy that was centered exclusively on generating income (again, in the form of interest from bonds and dividends from stocks) as income yields were sufficient to do so and nearly all stocks paid dividends.  However, relying on income alone has become a much less sound strategy than it was in the past.  As we all are aware, interest rates are at all-time lows and are even negative in many cases.  Can any of us recall the last time we saw a CD or money market rate that had a number other than zero to the left of the decimal point?  Stock dividend yields are not much better; they too are at all-time lows due largely to income-seeking investors driving the prices of dividend-paying stocks up, which in turn drives the yields down.  What’s worse is that in this day and age it is far from a “given” that a stock will pay a dividend at all.  This is not necessarily a bad thing. (More details on that shortly.)

As I pointed out in a previous blog post (Inflation: The Slow, Sneaky, Silent and Stealthy Portfolio Assassin – November 24, 2015), a portfolio must have a return at least equal to the rate of inflation in order to just break even in real terms; that is, maintain its purchasing power.  With dividend and interest yields as low as they are, relying on income alone is a risky proposition.  The return potential simply isn’t there.  Having too much invested in bonds in order to generate more income increases the risk that the value of the portfolio will not maintain purchasing power.  Also, stocks that currently pay dividends tend to be those of mature, large cap companies concentrated in certain sectors or industries.  Thus an investor who selects stocks based solely on dividend payouts will likely wind up with an insufficiently diversified portfolio that lacks a balanced asset allocation, and results in too much risk.   Instead, portfolio construction decisions should be driven by a proper and prudent asset allocation that is balanced and well-diversified with an appropriate risk/return profile, regardless of the income yield of the individual investments.

This is where the concept of total return comes in.  Total return is just what the name implies-the aggregate return from all sources, both income and capital appreciation.  More than ever, both sources of return merit equal consideration because income alone cannot be relied upon.  This is shown by the “prudent investor” rule instituted for irrevocable trusts in nearly all states.  This allows trustees to invest for total return and to pay a certain percentage of the trust assets to the income beneficiaries; this payout may be derived from income, principal, or any combination of the two.  In the past, only income and not principal could be paid to the income beneficiaries.  This became a major obstacle with income yields being as low as they now are.  The new rule allows the trustees to invest in more growth-oriented investments regardless of income payout, thus increasing the potential benefit for both the income and remainder beneficiaries.

In addition, since the 1980s, the source of stock returns has shifted toward capital appreciation and away from dividends.  Keep in mind what a stock dividend is: it is a payment of the company’s earnings, which is distributed to shareholders.  Making this payment is not required. A company may decide, at any time, to decrease or stop a dividend, not pay one at all, either due to poor earnings or a desire to use earnings for other purposes, such as reinvesting in the company or making acquisitions to foster growth, or buy back their own shares.  Using earnings in this way may result in greater returns in the form of share price appreciation than if the earnings were simply paid out as dividends.  Again, this is another reason to focus on total return, and not just income.  Smaller or fast-growing companies may have little or no dividend payout, but this does not mean they are any less worthy of inclusion in a portfolio.  What they lack in income generation they may more than make up for in potential for capital appreciation. 

Finally, deriving returns from capital appreciation as opposed to income can be more advantageous from a tax standpoint, as the investor has greater control over when a tax liability is incurred by the timing of asset sales and realizing capital gains. There is far less control over when dividend or interest income is received.

In conclusion, we must not despair when faced with low income yields.  We must not forget income’s less tangible counterpart-capital appreciation.  Together they make up what truly matters-total return.  That is what will help us reach our long-term investment goals.

Sources

Income Portfolio Versus Total Return Portfolio
What’s Best: Total Return or Income Investing
Income vs. Total Return Strategies – Why Take Sides?
Spending From a Portfolio
Dow Price/Dividend Ratio and Dividend Yield History
Does the S&P 500 Index Include Dividends?
Total Return Trusts: Why Didn’t We