Income Investing

In An Investing Primer we discussed a basic model portfolio for US based investors, from the rationale behind it to a specific implementation using exchange traded funds.  Of course one size fits all usually means it fits most people fair to middling, and that there’s considerable room for improvement when fitting a specific person.  There are all kinds of different circumstances and goals faced by real people in the real world, and there are just as many ways to tweak a core model to make it a better fit.  These things include age, time horizon, risk tolerance, the presence or absence of other financial circumstances outside of the portfolio itself (such as debt, other assets, sources of income), and whether the investor is more interested in capital preservation, growth, or income. 

Emphasis on income is controversial.  After all, isn’t the bottom line total return?  But even if it is, that doesn’t preclude a close look at income.  For one thing, besides income, total return incorporates price performance.  Can you predict price performance?  If you can, you can stop reading now and start your own investment firm.  What about your life expectancy?  Circle the applicable date on your calendar and chart the course of asset prices from now until then and you have all you need to proclaim yourself an exclusively total return investor.  The bottom line may be total return, but as a practical matter income is just more predictable.  There is even an entire asset class referred to as “fixed income”, but it certainly doesn’t mean fixed price. 

The Primer proposed a basic ETF portfolio consisting of:

SHV   10%  (Short term US Treasuries)
GOVT  40%  (US Treasuries)
IAU  10%  (Gold)
VT  40%  (Stocks)

This can already be considered an income portfolio in that 90% of it pays regular interest or dividends.  The 10% in gold is a nod to capital preservation and risk management.  Looking at income does not necessarily mean trying to maximize income at the expense of safety, capital preservation, or total return.  Doing that would put at risk the sustainability of the very income we’re interested in in the first place.  But that’s doesn’t mean we can’t tweak the portfolio to add a bit more yield without sacrificing these other important considerations either.

One such tweak, for example, might be the following:

SHV   7.5%  (Short term US Treasuries)
GOVT  42.5%  (US Treasuries)
IAU  7.5%  (Gold)
VT  42.5%  (Stocks) 

Longer term Treasuries typically yield more than short term Treasuries, a phenomenon referred to as a positively sloping yield curve.  And since there tends to be an element of negative correlation between stock and Treasury prices, this can help buffer some of the volatility increase from the like increase in the stock allocation.  And since stocks as a whole (VT basically tracks the world stock market) have yield while gold doesn’t, this slight reduction of gold in favor of stocks also increases the yield of the portfolio.  In addition, as we discussed in the Primer, the use of world stocks as opposed to exclusively US stocks itself reduces somewhat the need for gold as a hedge against a falling dollar.

Here in 2018, the US stock market is notoriously price gain oriented.  And yield poor.  US corporations very heavily favor stock buybacks over dividends as a means to provide returns to investors.  This is not necessarily in investors’ best interests, however, as a great deal of this is motivated by the way in which corporate executives are compensated via stock options; buybacks tend to enrich insiders disproportionately over other shareholders. Moreover, it means the stock owner must sell in order to realize returns.  This puts investors in the position of playing a game they may not wish to play, trying to determine the best time to sell part of their stock positions, and possibly risk having to sell at unfavorable times at unfavorable prices.  With dividends, the stock owner need not sell, but can simply buy and hold, a much simpler proposition for most of us, including retirees.  It bypasses the whole question of guessing your life expectancy and gambling on a drawdown plan incorporating some possibility of outliving your assets.  It also puts corporate stock on a more even footing with other investments like bonds and rental real estate … why should someone expect you to hand over the use of your hard earned capital without paying any rent on it?  Just trust me, I’ll make it grow?

With that in mind, another tweak to our basic model could involve substituting a part of the VT position with a dividend-oriented US stock fund along with an international fund (to maintain the global balance).  For the latter, I like VXUS, Vanguard’s ex-us world stock fund.  It holds several thousand stocks covering essentially the whole world except for the US and does so at very low fund management expense.  For the former, I like DTD, Wisdom Tree’s US Total Dividend stock fund, which owns the US stock market essentially in proportion to each stock’s total dividend payment stream.  With this modification, the basic portfolio might look like this:

SHV   10%  (Short term US Treasuries)
GOVT  40%  (US Treasuries)
IAU  10%  (Gold)
VT  20%  (Stocks)
DTD  10%  (Stocks)
VXUS  10%  (Stocks)

It’s perfectly fair to say we have added some income emphasis here, yet I think it would be difficult to impossible to make a cogent case that anything material has been sacrificed on the capital preservation, risk, or total return fronts.  We’ve retained the most essential features of the Global Market Portfoio and Permanent Portfolio we started with.

It’s not hard to imagine further tweaks along these lines.  We could add a bit more income and diversify more broadly at the same time by substituting part of the stock allocation with master limited partnerships (MLP).  Unless risk is to be increased instead though, this will be a small part, as MLPs make up not only a small part of the investable capital markets but also can be volatile and perform poorly even when the rest of the equity universe is doing well, as the past three or four years demonstrates.  Since MLPs are not included in the major stock indexes, and certainly not in any of the above stock funds, this small addition adds no overlap or excess concentration.  This can be done via ETFs as well, for example AMLP.  Other equities also not covered in the major indexes include business development corporations (BDC) and mortgage REITs.  These can also be used in small amounts to increase the yield of an equity allocation.  Including a bit of corporate or municipal bonds, even junk bonds, as part of the bond allocation can increase the yield somewhat, though at the expense of higher risk, as discussed in the Primer.

Be aware, however, that besides having unique risks of their own, there is generally a trade off between current yield and growth of yield … higher current yield tends to be compensated by lower growth.  MLPs, BDCs and mortgage REITs may even sport double digit current yields, but dividends may not keep pace with inflation, meaning real dividends may decline.  Even in nominal dollar terms, dividends may decline.  The upshot of this is that over a long period of time the net forward yield of a high current yield security may be less than that of one with a lower current yield.

Investors who understand corporate finance and in particular are comfortable with reading balance sheets and other financial statements could further substitute part of their equity allocation with a selection of individual dividend paying stocks.

Regardless, allocations to each major asset class – bonds, US stocks, non-US stocks, cash/equivalents, gold/commodities – should be maintained at the targets you have selected; in virtually any reasonably diversified portfolio allocation by asset class is a much bigger determinant of return and risk than selection of securities within each class.

Let’s acknowledge here that we’ve somewhat mixed two separate issues regarding income orientation: retirement financial planning based on income on one hand, and actually constructing a portfolio with income as an explicit goal.  You can think about your retirement portfolio and plan to rely on the income it produces (as opposed to drawing down capital based on life expectancy assumptions) regardless of how you actually configure your investment portfolio.  It doesn’t necessarily mean you select your investments to emphasize income.  You can do that as well, but neither automatically implies the other.

The usual caveats of any investment portfolio apply.  You can expect that prices will decline at times.  If you sell at such times you will incur a loss.  Income will decline at times.  Odds are however that over the years and decades, a portfolio constructed along these lines will appreciate in dollar terms and likely in real terms as well, and that the stream of income produced will do the same.  Independently research any investment you’re considering, and always consider professional advice tailored to your individual circumstances and goals.

So here is a basic template or recipe for constructing a moderate allocation model portfolio that can be used as a starting point for long term income generation.  Season to taste…

 

 

7 thoughts on “Income Investing

  1. jk says:

    readers might want to check out portfoliocharts.com to play with different asset allocations and see how they performed over the past 45 years. i especially recommend a careful look at the “golden butterfly” portfolio and its various return characteristics.

    for those interested in tactical asset allocation, the website allocatesmartly.com is of particular value.

    also a couple of writers on seeking alpha publish interesting [imo] pieces on income investing. steve bavaria is particularly interesting in that he doesn’t care about dividend growth or stock price. rising stock price is “winning the race” in his terms, whereas being able to maintain a dividend stream just requires “finishing the race” – a much lower bar. another writer of interest might be dale roberts. and if you get into the comments to their articles, you can find a number of others worth paying attention to if you want to go down that road.

    1. Bill Terrell says:

      Thanks for the suggestions, JK. Let me add another: Alhambra’s Fortress Portfolio https://www.alhambrainvestments.com/2018/09/10/global-asset-allocation-update-september-2018/ (moderate allocation pie chart at bottom of page). This is the latest update in a dynamic allocation process as opposed to a static all-weather model, but it’s noteworthy that sometimes these allocations are less different than they first appear. Looking at the broad outline of Alhambra’s allocation for example, it has 40% world stocks, 10% gold/commodities, and 50% US Treasuries, just like the first and third models cited above. Alhambra’s is more granular, specifying 14 smaller allocations as opposed to the 4 or 6 larger ones in the above. I wouldn’t expect any major divergences in risk and return characteristics between them. A hypothetical choice could easily come down to a matter of portfolio size; it’s more practical to subdivide a very large portfolio more ways than a smaller one. More granular also means more opportunities to tweak, so an investor’s inclination to do so would also be a factor. Regardless, Joseph Calhoun’s detailed economic insight is recommended reading for any investor.

  2. jk says:

    btw i think you make a very strong case for the benefits of income investing. i’ve always been a proponent of total return investing, but your article here is making me reconsider that, especially later in life. unfortunately this appears to be a particularly bad time to initiate an income approach in that rates are rising and so prices are going down. if this bear market [by your definition] extends itself, an income portfolio will take a double hit: because rates will be rising, pushing down the current value of income payers; and also there will be a tendency for the equity based vehicles to go down with the general stock market. traditionally a strong dividend has been seen as a bulwark against falling prices, but i don’t see how that works when prices are falling because rates are rising.

    i suppose the trick is to buy income producers just after the fed realizes it has indeed “broken” something.

  3. Bill Terrell says:

    You can think of it as a matter of degree; for instance you can base retirement withdrawals on income as opposed to life expectancy without changing your portfolio at all. It’s a personal preference. I don’t like depending on a life expectancy assumption, partly because good health and scientific advancements might result in longer than expected life and consequently a risk of going broke. Partly because I don’t like how it feels to spend down capital. Conversely, someone who is comfortable with probabilities and has no desire to leave a legacy to heirs could reasonably prefer a drawdown strategy. The point in raising the issue is that most conventional advice is to draw down capital and that there is a reasonable alternative for folks who aren’t comfortable with that.

    It’s become more reasonable as interest rates have risen. Even without modification a basic balanced portfolio like the first one above yields more than it has for most of the past decade. And taking it a step further, small modifications can increase the income without sacrificing the basic total return and risk characteristics of the portfolio.

    If interest rates rise further, virtually all long duration assets could see falling prices. Short duration assets, however, could see distributions rise with little impact to prices. Half of each of the ETF portfolios above, for example, are in US Treasury funds. GOVT covers maturities from one to thirty years, but is market weighted so that the bulk of the portfolio is in maturies less than ten years. Because of the turning over of short term bonds, even though the price has declined 3-4% this year, interest distributions have been growing at a 15-20% annual rate. SHV covers maturities of less than one year, and its interest distributions have been growing in excess of 60% annualized with no perceptible price decline.

    Even though it wasn’t designed particularly for income, because 90% of it pays interest or dividends, the first model portfolio can be considered an income portfolio even without modification. The third model ETF portfolio, with a modest income enhancement, differs only on the equity side of the equation. There, while it yields nearly a percent more than the US market at large, DTD hasn’t shown a markedly different total return profile, and could even outperform in a down market by virtue of passing on some of the most overvalued non-dividend-paying high flyers (e.g. FAANGs). It is very broad, however, currently holding over 800 stocks – more than the S&P 500 – including dividend paying megacaps such as top three holdings Apple, Exxon Mobil and Microsoft. And even then, compared to the basic model portfolio it’s only replacing part of the VT position, leaving most of the overall equity position cap indexed to the global market.

    As always investors should make their own final determinations based on their personal priorities; these model portfolios are primarily to illustrate the principles involved. Those who have special reservations about the potential impact of rising rates could for example further emphasize shorter duration assets and make gradual changes as they see fit.

  4. jk says:

    if, as i think likely, the future is one of rising nominal rates but negative real rates, short dated treasuries will do a reasonable job of limiting the losses to inflation. that’s certainly what happened in the 1970’s. presumably the equity side of the portfolio will benefit from inflation, but won’t keep up if the inflation is extreme. all in all it’s not a bad defensive scheme.

  5. jk says:

    ha. there’s little chance i’d forget gold. i’ve had a significant position since it was 380/oz. i’ve tried to trade around my position and failed miserably, so i’m sitting with it. “sit tight and be right” as jesse livermore said, although i think it may be years before it makes an important move again. it’s currently about 16% of my portfolio.

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