Total Return vs. Income Investing: Same, but Different

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Retirees can take two main approaches to spend 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 dividends, 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 principal. 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) was $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. From 1963 through 2019**, the average proportion of firms paying dividends in the US was about 52%, meaning an investor focusing only on those stocks is missing out on nearly half of investible US companies. 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, but the average dividend payout ratios for those companies are all over the map, as well. This means you won’t get a true representation of different markets across the world.

In addition, a dividend's value, while not subject to the same degree of fluctuation as a stock price, isn't guaranteed. In 2010 more than half of the dividend-paying firms cut or eliminated those payouts following the financial crisis*.

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 long-term portfolio performance. You need to focus on the things that are actually under your control, such as taking the right types of risk and diversifying as much as possible. These things get you through retirement, not gimmicks like income investing.

*Black, Stanley. March 2013. “Global Dividend-Paying Stock: A Recent History.” Dimensional Fund Advisors white paper.

**Source: Dimensional, using data from CRSP. Stocks are sorted at the end of each June based on whether a dividend was issued in the preceding 12 months.

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