I participated in a live webcast recently on the topic of earning income in a low-yield environment. Here’s a recap of a few of the themes from that session.
One of the persistent questions from the seminar was how long the low-yield environment might last. Rates should be seen as a symptom of the sluggish economic growth that has come in the aftermath of the global financial crisis. A financial crisis is often followed by a slow economic recovery and is often associated with low rates as the monetary authorities seek both to stabilize the financial system and to promote economic growth. That said, it’s anyone’s guess about the exact timing of when rates will begin to rise. So investors, as usual, need to build a portfolio to address a number of scenarios, including stable or higher rates over an uncertain time horizon.
This question about low rates highlights a growing divide with how many investors approach the problem of generating portfolio income. Many investors take an “income investing” approach, living off income yields from stocks, bonds, and other assets. In order to increase income, they switch to higher-yielding (and higher-risk) investments—for example, by moving to long-term corporate or high-yield bonds.
By comparison, many financial planners take a “total return” approach to income. In this approach, the investor sets an overall portfolio allocation of stocks, bonds, and other assets based on long-term risk tolerance. And then the investor spends in a disciplined way from the portfolio according to some spending rule. The amount spent from the portfolio can consist of income, capital gains, or principal over time.
As an illustration, a traditional retired income investor with $100,000 to invest today might be able to squeeze $3,000 worth of income (after expenses) from a diversified portfolio of higher-risk bonds and higher-yielding stocks. By comparison, the same investor with a total-return approach would invest that $100,000 in a broadly diversified portfolio of stocks, bonds, and other assets (not tilted toward higher yields) and then draw down, say, 4% of portfolio assets. (If the $100,000 were in a taxable account generating taxable income of 2% or $2,000, the investor would first spend that $2,000 and then withdraw another $2,000 of principal. If the money were in an IRA, the investor would redeem 4% of the total value.)
Many traditional investors object to this model, saying that it’s too risky to be drawing down principal when stock prices are volatile. But they tend to overlook the risks associated with traditional income investing. When you tilt your portfolio to high-income bonds, you ramp up your exposure to interest rate risk. When you tilt your stock portfolio to high-yielding equities, you typically also tilt it away from future growth. This is particularly true if the high-yielding asset class (think, for example, about the recent run-up in dividend-paying stocks) has become fashionable and is quite expensive.
In the total-return approach, there are two ways to mitigate worry about periods when stock prices are falling. The first is to manage risk in the long-term portfolio. I’m continually amazed by the number of retired investors I meet who are worried about stock market risk, yet maintain stock market allocations in their portfolio of 60%, 70%, or more. If you’re in the spending phase and want to reduce the sense of psychological risk coming from spending down assets, a lower-volatility portfolio may be in order—consider something in the neighborhood of 35% to 50% of assets.
Second, consider keeping a cash buffer of one to two years of living expenses in a separate account, making transfers from your long-term portfolio to this account once or twice a year. This behavioral device, based on the principle of mental accounting, which segregates spending money from long-term assets, may provide some relief from worries about the volatility of the long-term portfolio.
I’m realistic that many investors will still stick with the traditional income approach. That means the search for higher yields entails moving, in today’s environment, to longer-term or lower-quality bonds, as well as stocks paying higher yields. But investors shouldn’t forget to weigh the risks—which include the increased level of interest rate and credit risk in such a portfolio, and the concentration risk associated with investing in specific stock market sectors.
Notes: All investing is subject to risk, including the possible loss of the money you invest. Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments. High-yield bonds generally have medium- and lower-range credit quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit quality ratings. Diversification does not ensure a profit or protect against a loss. Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.