Total Return vs Income Investing
A common investment question I hear is “How can I generate more income from my investments to live off of?”
Unfortunately, I see people make bad decisions in a quest for income when they are asking the wrong question in the first place. Instead of focusing on income generation they should first be asking if their investment portfolio is focused on expected income production or total return after taxes.
- Income from investments is the distribution of interest and dividends
- Total return combines the income plus capital gains
When you have a long time to invest, focusing on total after tax returns can potentially provide a better overall investment performance because you are trying to generate more capital gains. Withdrawals from a total return focused portfolio shouldn’t be based on the income the portfolio is producing, but rather what reasonable growth will allow you to not outlive.
Income production can be a great approach when you are looking for a shorter-term investment with small growth and low risk. When people try to enhance income in a long-term portfolio they typically increase their risk more than they realize through one of the following strategies:
- Overweighting long-term bonds, which mean purchasing bonds that have a significant time until maturity. This may increase your yield, but it will also increase your portfolio's exposure to changes in interest rates. While the claim that interests rates will be going up has been over exaggerated for years now, I still wouldn’t recommend taking a big risk in this area.
- Overweighting high-yield bonds. High-yield bond is a nice way of saying junk bond. High-yield/junk bonds produce more income for a reason. They come with a higher chance of failure and are likely to take a larger hit in an economic downturn.
- Increasing exposure to dividend-centric equity. Choosing equities that are focused on current dividends rather than the income plus potential company growth decreases the diversification of your equity portfolio. To do this, you have to overweight certain asset classes and sectors which will increase your portfolio's overall volatility and risk of loss in an economic downturn.
When creating a total return portfolio you potentially produce advantages for generating higher after-tax returns to live off of:
- Withdrawing from long-term capital gains. When you sell an investment that was purchased over a year and a day prior to sale, the government assesses a lower tax on the growth than it would have on income.
- Withdrawing from the items that have grown out of balance. As the value of investments change, your risk will stray from your original intention. Strategic sales for withdrawals allow you to shift your risk back to your original target, maintain fewer transaction costs and obtain the funds you need for your lifestyle.
- Creating a lifestyle on long term withdrawal ability instead of short-term cash flow. A top goal of most people I talk with is to not outlive their assets. You can achieve this by designing a sustainable withdrawal rate. A sustainable withdrawal rate is not based on the income produced from your investments in a given year. Many of society’s long term retirees are seeing the income they once achieved driven down by current interest rates, which puts them in financial jeopardy. They once lived on a relatively high-income cash flow from their investments that may no longer exist. By focusing early on an appropriate withdrawal rate, you can avoid this dependency on income that has proved harmful in some instances.
Total return investing is not the answer for everyone, but it is the answer for far too many who have been convinced to focus on income first. Before asking how to generate more income, explore if income production is the answer to your objectives.