There might not be many areas with more confounding terminology than that of investing. Even some of the very basic terms and concepts can leave you scratching your head.
An example of this: Portfolios are often referred to as ‘growth portfolios’ or ‘income portfolios’. Sometimes, we’ll get really clever and make reference to a ‘growth and income portfolio’. The purposes for the different type of portfolios seem logical enough. While saving for retirement, your objective is to grow assets, and you’d want a growth portfolio. When you’re in retirement and need income, you’ll want an income portfolio. Same thing with foundations and endowments. During their building period, growth is the objective and when in distribution mode, income is the objective.
The confusion starts here: Most growth portfolios generate some income, and most income investors also want to see some growth in their portfolio.
The concept of ‘income’ means different things to different investors. Income, to a stockholder, can take the form of dividends, which are earnings paid back to stock investors. Often, stock investors prefer dividend-paying stocks, because they feel the dividends represent ‘real’ earnings (they must be real because they got paid out!). To a bond holder, ‘Coupon Payments’, paid at a percentage of bond face value, may be a source of income. Often, these are set up as semiannual payments, although they may occur at different intervals. Depending upon the bond itself, they may come out annually, monthly, or not at all! Investors in bank accounts and certificates of deposit, or in fixed annuities, receive interest payments as income.
A big part of the confusion, however, lies in the fact that the investors receiving these dividends, interest and coupon payments, may not be getting a ‘check in the mail’ (or a deposit to their bank account) when they receive this ‘income’.
On the other hand, investors who need income (because they’ve retired, for example, and need money to come into the bank account), can move money from an investment account to a savings or checking account. They may refer to that as ‘income’, even if it has nothing to do with the amount of dividends, coupon payments, etc. paid off by the investments.
Both of these definitions of income have their merit. Dysfunction, however, can occur when we use both definitions in an overlapping way.
- A retiree deciding they need $40,000 per year in income and, given their $1 Million portfolio, make the decision that they need to invest only in stocks that pay 4% dividends.
- An endowment investment committee member who is dissatisfied with a portfolio that only ‘yields’ 2.8 percent when they need to spend 5% of the portfolio annually.
A couple of problems present themselves when portfolios intended to provide income to support a household or organization are invested solely as ‘income portfolios’. EXAMPLE:
- George decides he needs $25,000 per year in income. He has a $500,000 IRA and allocates it in stocks and bonds that yield 5%. He finds that, relative to his benchmarks, he is heavily allocated to certain sectors, like real estate and utilities. He has almost no exposure to others, like industrials and telecom. The bonds in his portfolio are similarly selected to provide a 5% annual coupon. While his portfolio is set up as 60% stocks and 40% bonds, the volatility is well above the average 60/40 portfolio, because he has significant sector concentration and invests in exclusively higher yield (lower credit quality) bonds. Not only that, but because two of his stocks end up lowering their dividends, he ultimately receive less than the $25,000 he counted on.
Sector exposure can have a huge effect on overall portfolio performance, and experts largely attribute risk/return characteristics of portfolios to the overall asset allocation. An investor who tries to force a portfolio into a certain level of yield may unwittingly leave themselves with a portfolio that employs risk inefficiently.
A well-balanced, appropriately allocated portfolio may not have the ‘yield’ (through stock dividends, bond interest, etc.) to provide the amount of ‘income’ they wish to distribute. It’s a perfectly acceptable practice, in this case, to SELL some of the investments in order to keep up distributions, as long as the overall distribution rate doesn’t run the portfolio out of money before it’s supposed to.
If I own a $50,000 investment, and its value rises to $52,500, but it doesn’t pay any dividends, am I worse off than if that investment paid a 5% dividend but didn’t go up in value? From a practical standpoint, the answer is ‘NO’. In either case, I’ve got the same $52,500. If I want to take $2,500 in income from this asset, I can take the dividend (from the first dividend-paying stock) or simply sell off $2,500 (from the non-dividend-paying stock).
From a tax standpoint, avoiding higher-income investments may make sense in certain account types. Outside of tax-deferred accounts, bond interest is largely taxable at the normal tax rate. Stock dividends may be taxed at the normal tax rate or the lower capital gains tax rate. A portfolio that pays out distributions by gradually selling off holdings may be more tax-efficient than one that strives to generate income, as the sold-off gains will be taxed at lower rates if held more than a year.
This is all a long way of getting to the ultimate point: Don’t pay too much attention to ’yield’ in a portfolio, even if you need to take distributions. Focus, rather on achieving a good allocation overall, and use distributions as opportunities to rebalance. Take distributions in excess of income from assets that have grown too large in your portfolio.
It takes a bit more work, and sometimes additional trading, but the trading part is becoming less of a cost concern in today’s no-to no-commission environment. In the end, though, NOT seeking out an income portfolio for income distributions may afford the better results, both before and after taxes and fees.