In this month’s edition of “Money Matters,” Scott talks about why it is important, particularly for retirees, to consider a total return investing approach, rather than only an income portfolio approach, in their financial management plan.

Money Matters: Total Return Investing Versus Income Portfolio

0:00:00.0 CJ: WTIP is pleased to bring you another edition of Money Matters, a monthly feature intended to help us understand more about managing our finances. Scott Oeth is a certified financial planner and adjunct professor. He works with many individuals and has taught retirement planning and wealth management strategies to hundreds of financial professionals. And Scott's joining us now by phone. Welcome, Scott.

0:00:24.6 Scott Oeth: Good morning, CJ.

0:00:25.5 CJ: Good morning to you. So, you thought we should talk about how one can develop an income stream from their portfolio.

0:00:33.5 SO: Yes, an important topic. I think this is the goal of many long-term investors. You put away extra funds, you save in your retirement plan at work or an IRA or an investment account, and the idea is that you're hoping to build up some assets that at some point you can turn around and have those help support your lifestyle and create some spending money. But how? What's the way to do that? Especially when you think about investments that float up and down in value. And so, CJ, a couple of things. First of all, our usual disclaimer, this is an important area and I think people really need to do their own research. We're having a general conversation here, and I really advocate getting professional advice, but I also want to attempt to kill a sacred cow here this morning, or at least poke a hole in it. So, there's this long-standing idea that when you're in retirement, you should build an income portfolio, you should buy assets that generate income, interest, and dividends that are paid out to you, but never touch the principal. That is, you don't sell the core holdings. Have you heard this concept?

0:01:36.4 CJ: Oh, very much so, yes.

0:01:38.1 SO: Dividends principal. So, I've been doing this for several decades now, and especially earlier in my career, a lot of wonderful folks I had as clients, that depression era or their parents where this was so hardwired into them: never touch the principal, only live off the income. In some ways, it worked fairly well at a different point in time, when dividends were higher and interest payments from bonds were higher. You and I have talked about both of those components in past episodes. We've talked about the importance of stock dividends.

0:02:07.9 SO: I'm a big fan, but what I want to tell you this morning is that I don't think we should solely rely on those. With interest rates coming up since the last couple of years with the big inflation fight, bonds also are generating some valuable interest income for the first time in ages. Those are valuable components and this idea, this income portfolio, to just live off the income, it seems prudent, it's intuitive, it's disciplined. You won't spend down your capital. It really does have great psychological appeal, but the thing is, CJ, after a lot of research and many years of doing this professional investing for retired clients through lots of different market cycles and given where the market is today and how things have changed, I don't think focusing solely on income investing is the best approach in all cases. Really, for many investors today, especially retirees, I think they'd benefit from taking a total return approach to their investing.

0:03:07.3 CJ: Okay, so, bond interest and stock dividends, valuable sources of your portfolio's income, but you're saying not to rely solely on them, and how come? Why not?

0:03:18.2 SO: There are several issues, CJ, and some of the problems, a big one is to generate more portfolio income. Prices have risen, right? I think it's no surprise. We've talked about inflation a lot. People say, "Well, gee, I could use a little extra. How do I get more income?" What you'll see folks doing is they start, the term we use is reaching for yield. So, they start migrating from safe bonds, things like US Treasury bonds or high-quality bonds—things that would typically be considered safer—into bonds that generate or pay out a higher yield. To do that, the natural trade off, the economic law is that those bonds are going to be either more volatile or riskier in their credit quality. So, they might start buying bonds that don't come due in two years or three years or five years, but ones that come due in 20 or 30 years. When we buy those longer bonds, they're much more sensitive to interest rate fluctuations. If interest rates go up in value, they're going to fall in price a lot more, and for a lot of people, that was a very painful lesson in 2022 when interest rates spiked. Bonds took a tremendous hit if they were long-dated bonds. Or you hear your friend at coffee in the morning has a certain bond or a stock that's paying a high yield, and it sounds great because they say, "Ah, gee, it's kicking off 6% or 7%," or maybe it's a fund that's paying higher.

0:04:38.3 SO: Yet to peel back the layers and say, "What is it? What are they owning?" It might be a stock that is a low-quality company, so it needs to pay a higher dividend or it's a fund that is using a bunch of borrowed money to help generate those payments. So, the reaching for yield concept on both the bond and stock side can really cause a portfolio, in what seems like a safe conservative approach, to be a more volatile one, a riskier one. It's a problem, and I mentioned the market's changed, it really has. Dimensional Fund Advisors did a study and they found that in the '50s, 90% of US companies paid a dividend. By 2021, that number dropped to 38%. So, a lot fewer companies are paying dividends now, and stock yields, the dividends, they were commonly in the 5% plus range back in the 1950s. The idea was that stocks were riskier than bonds. They had to pay out a healthy dividend to encourage people to own them. That all shifted, and by the time we get to the 2000s, the stock dividend is in the 1-2% range. So, fewer companies are paying dividends and they're paying typically a much lower rate, which resulted in the income approach really getting squeezed, and it was causing people to stretch into riskier type holdings.

0:05:55.8 CJ: All right, so, there are some long-term disadvantages then to relying purely on investment income. So, what are the advantages of the, I think you called it the total return portfolio design and how does that work?

0:06:10.6 SO: Total return is really just adding another element. So, I do like stock dividends, and like I said, we've talked about that. We have a whole episode archived of value component, especially for retiree of their income and retirement; and bonds, a well-designed bond portfolio paying off interest income can be a very valuable piece as well, especially during those inevitable stock market storms. The total return approach is adding another element that says we're also going to have holdings that are designed for long-term growth and capital appreciation, stocks that are going to go up in value. That opens the stock market greatly—a much broader universe of investable assets—which helps with your diversification, or it can help with volatility, it can really open a big opportunity instead of other investments. Then, coming to a comfort level that at times we will sell holdings, and it is okay to sell the principal because it's gone up in value.

0:07:12.7 SO: So, as you're maintaining that portfolio and you're rebalancing and you're saying, "Okay, where am I going to get income?" Some income is coming into your checkbook from bond interest payments, some is coming in from stock payments, but, at times, especially after a good run in the market, it's okay to shave off some of those gains and maybe rebuy bonds or just add that to your spending portfolio. So, it can potentially deliver higher long-term returns, and we don't even have time to get into it really, CJ, but it's often a more tax-efficient approach overall. You and I have talked a lot about inflation and the pinch that inflation can bring for retirees, and the total return approach, I think, does a much better job of holding up and maintaining purchasing power in the face of inflation over the long haul. With the income approach, you can buy a bunch of holdings that kick off great income today and it looks good, but over time, I think, as I say, in many cases, people would really do well to evaluate a total return approach in their retirement portfolio.

0:08:15.9 CJ: Is there a source, a good source you would recommend for people to learn more about this total return approach? Do you have something on your website? I know you've got a lot of information posted there.

0:08:27.0 SO: Yes, I do. So, there's a lot on my website, just on scottoeth.com, and we have some related topics; we've had a whole episode we've talked about bonds and interest payments. We've talked about stock dividends. Recently, CJ, you and I talked about the 60-40 portfolio and how that's a very enduring approach, and we touched on some of these concepts there. Vanguard is a very well-known, large investment firm. They have some nice pieces on this concept, as does Charles Schwab. If you go into your search engine and search total return investing versus income portfolio, I think you'll come up with quite a bit of information there, and I'll post this piece and put some related links on there as well.

0:09:17.2 CJ: Nice. Thank you, Scott.

0:09:18.8 SO: Always happy to field the questions from listeners, too. We've had a lot of fun conversations coming out of these episodes.

0:09:24.7 CJ: Talking with Scott Oeth. We're talking finances with Scott on the first Wednesday of the month on North Shore Morning.

0:09:28.3 SO: Thanks, CJ.