Reading an article from an Australian investing site, the author, who claimed to be a former financial adviser, was explaining the ‘pitfalls of total return investing’. He claimed the concept of total return investing was to “live off dividend and interest income in the years when the portfolio declines”.
He went on to say that in a low interest rate environment where dividends and interest are both low, you’d be forced to sell some assets when they were low to make up the shortfall, thereby depleting your assets. He suggested higher dividend stocks would provide an advantage because you would be selling less stocks when they were low and therefore depleting your portfolio less in a market decline.
I want to clear up these misconceptions.
Total return investing is where you look at the total return of your stocks as a single cohesive unit, and at the total return of your bonds as a single cohesive unit instead of splitting it up into income and growth components.
With total return investing. you view your portfolio’s asset allocation as consisting of a percentage of stocks and a percentage of bonds. When the stock portion declines, you don’t live off dividends at all.
Here’s what happens:
- First, you take from bonds what you need to live off.
- Secondly, you reinvest the dividends, buying stocks when they’re cheap.
- Thirdly, to maintain your stock-to-bond allocation, you would further rebalance from bonds into stocks if the market decline was deep enough, which means buying stocks when they’re cheap.
An example of how it works
Let’s say you went with a 60/40 portfolio, and let’s say you have a million dollars. That would come out to
At the end of the year, there has been a 33% market decline, and you had 3% of dividends reinvested along the way, so the total return is a 30% decline in stocks
$420,000 stocks (includes dividends)
$410,000 bonds (includes interest)
So you’re now around 50/50
To come up with that 420k figure for stocks the dividends have already been reinvested, buying stocks cheaper.
You then draw down your 4%, which would be $40,000 (actually slightly higher adjusting for inflation but just keeping round numbers for simplicity)
Since bonds are overweight at 50% compared to your target of 40%, you take this from bonds, leaveing you
So you’re now 53/47
Since you’re still underweight with your equities, you sell 7% of the 47% ($55,000) in bonds which leaves you buying $55,000 worth of stocks when they’re cheap.
The opposite of what the author suggested happens. In their misunderstanding of total return investing, you’re selling part of your stock allocation (by way of not reinvesting the dividends) when stocks are low, but in reality, you’re buying more stocks when they’re cheap.
It doesn’t matter how much dividends you’re paid out (or how much they fall) because they get reinvested back into where they were withdrawn from, and you’ll be living entirely off your safe assets.
As to his comment on using high dividend stocks – dividends are widely misunderstood. Many people believe that dividends are a separate return to growth, that taking dividends and not reinvesting them is different from selling shares, and that dividends can provide a reliable income. This is a fallacy. A dividend is a withdrawal. It’s not similar to a withdrawal — it’s an actual withdrawal.
Here’s how it works at a company level – after a company pays out wages, debts, and other obligations, it pays out a portion of the remaining profit as dividends.
If a company worth $99M is gifted $1M, its new value is $100M.
In the same way, when a company pays out $1M in dividends, its new value is worth $1M less.
When you don’t reinvest your dividends, you have a made a withdrawal.
Taking dividends is no different from a portfolio withdrawal, and when you take the dividends from high dividend stocks, you have made a larger withdrawal, which exacerbates the problem during a stock market decline.
This fundamental piece of information is lost when people arbitrarily split up their stock returns into income and growth components as though they’re somehow separate. Total return investing forces you to face the fact that your stock allocation really is a single cohesive unit and should be treated that way.