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Ignore The False Dichotomy

If you want a topic to start a flame war on a finance blog, Income vs. Total Return is almost as good as Active vs. Passive. But like the latter, the former is a false dichotomy. Why choose between them when you can have both?

In honor of Morningstar’s Income Investing Week, Christine Benz has posted an article on the importance of avoiding this false choice.

While I think it is fair to say that Christine hews to a relatively more income agnostic approach than I do, I certainly appreciate her point that you can’t afford to ignore total return when investing for income. We each need to draw the line for ourselves, but this is a useful framework for figuring out our own individual emphases.

But first, let’s take a look at the 2 solo approaches.

The Income-Agnostic Total Return Approach

This approach means that you plan on selling off part of your portfolio each year when you are in retirement/drawdown mode. The upside is that you can potentially have higher returns. The downside is that you may get killed selling into a downturn by dollar-cost averaging in reverse. This is very painful in a down market.

This can be alleviated somewhat by having a substantial allocation to bonds, but in my opinion the bond market as currently priced represents return-free risk. Bonds may not be correlated with stocks, but if the long-term returns stink, you might as well just use cash as a sandbag. If stocks are a bit overvalued, and I think they are, then bonds in general are screamingly expensive, unless we are in for 20 years like Japan after 1990.

The Total-Return-Agnostic Income Approach

There are those who invest only in the highest yields and don’t care about total return. Some of those folks are currently holding Kinder Morgan (KMI). They tell themselves that the price doesn’t matter because they are never going to sell it, they plan on just living off of their dividends.

But what if the dividend isn’t sustainable? With high leverage and 10-20% of cash flows coming from oil production, Kinder looks a bit iffy. They have already reduced their dividend growth projection from 10% per year to 6-10% a year. I have a hard time seeing how they will meet this goal without an oil price recovery.

As an income investor, you need to look very carefully at the business model to make sure it is in a defensive business whose cash flows will support the dividend even in a downturn. You definitely don’t want to be the last one out the door after a dividend cut on a stock like this.

The Best of Both Worlds: Income and Total Return

Which brings me to the sweetspot: substantial yields from defensive businesses that can grow their dividends at a good clip. The archetype is a 3% yielding stock that can grow 7% per year. Or a 5% yielder that can grow 5% per year. Bought at a fair price, such a stock should have a long-term total-return profile on the order of 10%. That should be competitive with the S&P 500 over a full market cycle.

10% total-return profiles from stocks with already substantial dividends are currently difficult, but not impossible, to find. But this general approach should generate good long-term returns at lower volatility than an index fund.

And the practical benefits of this strategy are a stable and growing annuity-like stream of dividends which you can potentially live off of, and that should keep you protected from inflation. It becomes easy to answer the question: When can I retire? When your dividend income is large enough to cover your expenses.

Now, this approach isn’t for everyone, as individual stock risk means you have to more actively monitor and manage your portfolio than an index fund investor, but the rewards can be very practical and solve much of the puzzle of how to turn your portfolio into a stream of income for retirement.

See also:

Morningstar’s Income Investing Week

Dwelling on Quality

McCormick Spice – Almost Perfect

The Power of Dividends

Berkshire Hathaway’s Latest 13F