Denton County Living Well Magazine Winter 2014 | Page 46
INCOME PORTFOLIO VERSUS
TOTAL-RETURN PORTFOLIO
Courtesy Portfolio Solutions, LLC
G
reek mythology tells us that Icarus flew too close to the sun on wings made
of feathers and wax. During Icarus’ escape from Crete, the heat from the
sun melted the wax holding his wings together, and sent him plummeting
into the sea where he drowned.
The story of Icarus is an allegory for
the danger of hubris. Investors ready
to fly into retirement should beware
the hubris of trying to live off of only
the income yielded from their assets
to avoid touching their accumulated principal.
As a retirement investor, your goal
is to transition your investment portfolio from a source of asset growth
into a consistent source of income;
however, by focusing on income
while overlooking growth, you may
fail to generate the cash you need
for retirement expenses — as well as
burn away your portfolio.
To illustrate, let’s see how an income
portfolio matches up with a total-return portfolio.
INCOME PORTFOLIO
An income portfolio predominately
favors assets that yield income, typically dividend-paying stocks and
bonds with high interest payments.
Its purpose is to provide an income
stream from your investments without having to tap your principal.
Some believe an income portfolio
has lower risk since you are not investing for growth, which can subsequently extend the life of your
money.
For most investors, however, the
ability to use only dividends and interest to fund retirement expenses is
nearly mythological itself.
Consider the illusion of dividends.
Dividends distributed to shareholders come from a company’s earn-
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ings. Typically, when a company declares a dividend its stock
price drops by the same amount when the market opens the next
day.
For example, you decide to invest $100,000 and buy 1,000 shares
of a stock that sells for $100 per share. The stock pays a $1-pershare quarterly dividend. In reality, you would have your initial investment (all else equal), but now it is $99,000 in stock and $1,000
in cash. Spending the cash would be the same as spending from
your principal.
A company doesn’t have to provide a dividend, and if it does, it
chooses when and by how much. Therefore, you have very little
control over this type of investment income.
Bond yields can be equally inconsistent and insufficient, especially during periods of low interest rates. According to a Vanguard
report, the historical average nominal return for bonds was 5.5%
from 1926 – 2012. Meanwhile, the median inflation rate from 1950
– 2012 was 3.1%. An all-bond portfolio would be highly subjected
to the corrosive effect of inflation, decreasing your buying power.
The small return is reduced further by investment costs and taxes.
This explains why bonds are better risk stabilizers than income generators.
From a return perspective, at best, an income portfolio may work
if you need a small income amount and have a large portfolio
balance.
In addition to potentially inconsistent and insufficient cash flows,
another disadvantage of an income portfolio is the loss of security provided by diversification. Broad diversification across several
asset classes can reduce your po