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For many investors, there is an intuitive appeal to owning income-producing investments and living on the cash flow they produce while leaving the principal untouched. We all understand that taking only the milk every day can sustain us far longer than eating the cow and the investing brain views portfolios and income in just the same way. The appeal is so strong that financial marketers happily package up products to capitalize on this way of thinking.

Intuitive appeal may help sell products, but it is rarely the best basis for making decisions. For investors looking to fund living expenses through retirement—ground zero for income products—the better approach is to seek the best overall return possible, consistent with acceptable risk, and use ‘total return’ to fund spending. The milk and cow analogy seems applicable, but it’s not. When it comes to investing, all sources of return become part of a broader portfolio measured in dollars.  A dollar taken from that portfolio and used to fund living expenses doesn’t know or care where it came from.

The purpose of this series of posts is to demonstrate why we believe a total return approach is a better option than a pure income approach when investing to fund living expenses, particularly in a low-interest-rate environment. We hope that convincing investors of this will pay them dividends in the form of better returns.

WHATS WRONG WITH JUST LIVING ON THE INCOME?

 In short, the answer—at least for those without a very high ratio of asset to income needs—is there isn’t enough income. For most investors seeking income, the goal isn’t just to fund living expenses; it is to have enough money to last the rest of their life and to keep inflation from eroding the value of their principal. A portfolio limited to vehicles that primarily cast off income will likely be a less reliable way to achieve those goals for several reasons.

  1. An exclusive focus on income rules out sources of return that may be higher. Is an investor really prepared to accept a lower overall total return just to have more of it come from income?
  2. In today’s environment, very low yielding high-quality bonds not only generate little income but also expose investors to losses in the value of their bonds when interest rates eventually rise.
  3. Reaching for higher yields may sometimes generate better near-term returns, but at the potential cost of higher credit risk and less downside protection than a more diversified portfolio offers. There are no free lunches in investing.

Part 2 will dive deeper into the topic of risk and Part 3 will summarize reasons to build portfolios with risk and return, as opposed to income, as a primary focus.  Finally, Part 4 will address how to tackle this ‘total return’ approach and address issues such as distributions, taxes, and perhaps out clients’ greatest concern, capital preservation.

 

Certain material in this work is proprietary to and copyrighted by Litman Gregory Analytics and is used by EFP Advisors with permission. Reproduction or distribution of this material is prohibited and all rights are reserved.

 

 

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