At Hill Investment Group, we recognize that when a few clients raise the same question, it’s likely that more have similar thoughts. To better serve you, we’re introducing a new segment in our newsletter where we’ll address common questions and how we approach them. To submit questions for future newsletters, email us at info@hillinvestmentgroup.com
Hey Hill, how can I think differently about the total return of my portfolio vs. focusing on income investing alone?
Throughout our working lives, we relied on our earned income to support our day-to-day expenses. Each year, we worked, earned a salary, and used that money to cover necessities such as food, housing, entertainment, and childcare. A consistent income stream provided us with a sense of security to fulfill our needs and save for retirement.
However, after retiring, the question arises: where will the income come from to sustain our lifestyle? While some may come from pensions or social security, these sources may not always be sufficient. As a result, investors often dip into their savings portfolio to supplement their income.
When considering how to invest their savings, investors tend to zero in on needing “income” to replace their salaries. They may have a funding gap and want to ensure their portfolio will yield a certain yearly income level through fixed-income or dividend-paying stocks. Although this approach is intuitive and may give retirees peace of mind, it does not maximize the odds of financial success. Why not?
Investment returns come from two places. Income (dividends and interest) and capital appreciation (prices going up). By focusing solely on income, you forgo the primary driver of returns: capital appreciation.
When you go to the store and buy new clothes, you don’t care if you pay with cash from your left pocket or your right pocket. Money is money, and the source is irrelevant. The same is true of investment returns. It does not matter whether those returns come from dividends or prices going up. What matters is the total amount of money you have. By focusing on income returns or just the money in your left pocket, you are not investing in the stocks or bonds with the highest expected total return. You are not maximizing the money you have across both your pockets. At the end of the year, this will leave you with less total savings.
Capital appreciation generally drives total returns much more than income. Additionally, capital appreciation receives favorable tax treatment. Gains from price increases are taxed at a lower rate than income. Thus, an investor would prefer their return come from capital appreciation vs. income because, after taxes, they will have more money to spend.
Therefore, rather than thinking about how much income my portfolio generates year by year, we encourage our clients to consider the total value of their investments and what that total level can sustain in terms of spending over a lifetime, understanding the ebbs and flows of the market. This approach maximizes our clients’ odds of achieving their financial goals.
Hill Investment Group is a registered investment adviser. Registration of an Investment Advisor does not imply any level of skill or training. This information is educational and does not intend to make an offer for the sale of any specific securities, investments, or strategies. Investments involve risk and, past performance is not indicative of future performance. Return will be reduced by advisory fees and any other expenses incurred in the management of a client’s account. Consult with a qualified financial adviser before implementing any investment strategy.
