Investments

Income vs. Capital Appreciation – Why Not Both? A Total Return Approach

Too often, well-intentioned advice falls short of the optimal real-world outcome. The danger usually lies where an adage becomes a heuristic applied to a complex situation. One such cliché that has come to impact portfolio allocations is that you should “never touch the principal”. This philosophy qualifies as such well-intentioned advice. But is it optimal? After considering all factors, probably not. The idea is that if you do not touch the principal of an investment portfolio when you make a withdrawal, the principal will remain intact and provide a source of return for the long-term.

While noble in approach, this may produce sub-optimal capital allocation if withdrawal needs exceed the portfolio’s income. The search for additional income to cover withdrawal requirements can lead to a portfolio focused on higher income (or yield) producing investments. This is the first source of inefficiency. Prioritizing income can lead to a portfolio with outsize risks. Over the past decade, central bank target rates in many countries have been near all-time lows. Near-zero central bank rates have led to lower rates on bank deposits, bonds, and even dividend yields on equities as investors tended to bid up dividend stocks in a search for income producing investments. In this low yield environment, investors have become desperate for higher yielding investments. But, as we know, nothing comes free.

Picking up higher yield usually requires taking on additional risks of one type or another. In the world of bonds, higher income usually goes hand-in-hand with excess credit risk or duration risk. Excess credit risk can make the portfolio more susceptible to downturns in the business cycle while increased duration risk exposes bonds to the risk of rising interest rates. In stocks, the risks are primarily related to price risk and sector exposures. A heavy focus on high-dividend stocks can lead to a process wherein investors prioritize above average dividend yields over the forward prospects of the investment. This can expose an investor to a greater chance of capital loss than a full analysis of future company value. This can endanger the principal that the income approach seeks to protect. Another side-effect of yield driven stock selection can be an overweight towards certain sectors that tend to have higher dividend yields such as utilities and telecommunication firms. Not only can this lead to an under-diversified portfolio, but it can also prevent exposure to sectors that end up with higher total returns. For example, large technology stocks in aggregate produce lower dividends than other sectors, yet they have been a leading sector for total investment gains over the past couple of decades.

There could even be negative tax ramifications of an income focus. The primary issue is that income produced by investments in taxable accounts is taxable in the year of recognition. An income security will pay out even if you do not need to recognize the income in that year. Taxable bonds can exacerbate this problem as the income is taxable at ordinary income rates. Qualified-dividend stocks can produce income that is taxed at lower rates, but the investor still lacks control over the timing of the tax liabilities. However, a non-income producing equity investment would allow an investor to delay tax liabilities until they sell the shares. Further, if the shares are held more than a year, any gains recognized would be taxed at a beneficial long-term capital gains rates just like qualified dividends.

This is not to say that income is the enemy. Income is an integral component of a portfolio. The approach must simply be tempered such that is it is not the driving force of capital allocation decisions, but rather a part of a total return approach. There will be scenarios in which the yield is an attractive component of an investment that meets all fundamental requirements. In other scenarios, the optimal long-term investment may be in a stock that does not offer a dividend yield. Each investment’s place in a portfolio must be individually justified for overall portfolio optimization.

To put the concepts into context, assume an investor needs to withdraw 4% of their portfolio a year to cover expenses. A portfolio yielding an income of 4% that has little to no capital gains potential (a realistic concern in today’s environment when constructing a portfolio with a “yield first” mindset) would be sub-optimal if another portfolio yielding 2% has the potential for annual capital gains of 4%. If the lower yielding portfolio makes up for 2% income shortfall by recognizing long-term capital gains, the portfolio will be able to produce the necessary funding, in a tax-efficient manner, while increasing the value of the portfolio while the “income” approach would likely stagnate. Return projections will of course vary over time, so the answer is not that we must always select a lower yielding portfolio or a higher yielding portfolio, but rather to address each environment individually given with the facts of the situation.

Undoubtedly, certain unique situations call for an income focus for tax or legal reasons. In such situations, the capital allocation decisions will follow a different path. However, for most investment portfolios, a total return approach produces stronger and more balanced long-term outcomes. As we see time and again, a holistic approach to portfolio construction is an integral component for long-term success.

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