For
decades, there has been a grand debate afoot in the investing world
between “total return” and “income” investors. The truly educated don't
worry about it much because they realize there isn't a lot to it. Your
goal should be to avoid an extremist or absolutist position on the
matter.
Income investing
The basic idea behind income investing is that you only spend the income
from your investments. Seems like a great idea, right? It's easy to
know when you have enough to retire—when the income from your
investments replaces the income from your job (or at least your living
expenses). Plus, you know you'll never run out of money if you're only
spending the income.
Unfortunately, if you become an extremist in this camp, you may get
burned by several issues. There are really 4 ways that income investors
get it wrong when compared to a "total return" investor.
1. Income investors are likely to underspend
Safe withdrawal rate studies, such as the Trinity Study, have demonstrated it is quite safe (although not perfectly
safe) for you to spend about 4% of a traditional portfolio each year
and expect your portfolio to keep up with inflation throughout a 30-year
retirement.
However, these days most traditional investments have a yield much less
than 4%. The Vanguard Total Stock Market Fund yields just 1.8% and the
Total Bond Market Fund is only slightly higher at 2.1%. CDs,
"high-yield" savings accounts, short-term bond funds and most muni and
Treasury bond funds are even worse. Even value stocks and REITs have
yields much less than that.
If you're only going to be spending the yield on these investments,
you're going to be spending much less than 4% per year. That means you
will need to do one of 3 things: have a higher savings rate, work
longer, or spend less in retirement. Since you are spending less, you
are also likely to leave a lot more money behind at death.
In short, you'll spend less than you could have if you were willing to
spend some principal.
2. Income investors may not hold the best portfolio
An
income investor is far more likely than a total return investor to
chase yield, since every little bit of extra yield increases his or her
lifestyle. However, there are many investments with a high yield whose
total return may not be what you would hope. The classic example is junk
bonds, and the junkiest of junk bonds these days are peer-to-peer
loans.
A portfolio of peer-to-peer loans may yield 20%, while only having a
total return of 10% due to a high rate of default. If you're spending
20%, that portfolio isn't going to last long. That doesn't mean there
isn't room for higher yielding investments in your portfolio, but you
want to make sure you are holding a diversified portfolio with excellent
long-term, risk-adjusted returns. Such a portfolio almost surely will
include some assets that have a low-yield.
Never forget that a yield of 8% is not the same as a total return of 8%.
While it feels good to have an 8% dividend in hand, if the investment
actually lost 25% in value, you’re not making much progress financially.
Investment real estate is a particularly attractive asset class for
income investors because a significant portion of the return comes from
income, often 5% to 7% of a 7% to 10% return. This yield is much higher
than anything available in the "paper market" outside of low-quality
bonds.
While income property can form a significant portion of your portfolio, a
portfolio of 100% real estate doesn't pass the sniff test when it comes
to diversification. In addition, real estate possesses significant
downsides as an asset class including significant maintenance and
transaction costs, aspects of a second job, and an inefficient market
requiring expertise and experience to get solid returns.
3. Income investors may pay too much in taxes
As a general rule, income tends not to be very tax efficient. There are
exceptions, of course, as muni bonds are usually federal, and sometimes
state, income tax free and some of the income from real estate can be
shielded by depreciation, especially early on in the life of a property.
Bond dividends, REIT dividends, and CD interest is taxed at your regular
marginal tax rates instead of the lower dividend and capital gains
rates available with stocks. To make matters worse, you have to pay
those taxes even if you didn't really want to spend that income yet.
There is no way to defer the income until you actually want it in the
future.
However, a total return investor can often "declare his own dividend" by
selling some of his investment—for instance, a few shares of stock. The
tax bill on that money (which spends just as well as CD interest) may
be very low when you consider the ability to sell high-basis shares,
harvest tax losses, and take advantage of the lower long-term capital
gains rates, especially in the lower brackets.
4. Income investors may get burned by inflation
Higher yielding investments, such as CDs and bonds, tend not to keep up with inflation nearly as well as traditional lower yielding investments such as stocks.
If you focus too much just on income, you may forget that your real opponent in the investing game is your personal rate of inflation. If your income is steady, or only increasing slowly, and your expenses are increasing at a moderate rate, it won't take long before you will be faced with an unsavory choice: cut your lifestyle or sell your investments.
A total return investor spending 4% of his portfolio each year has an inflation adjustment built in to his plan. An income investor needs not only to make sure his investment income is greater than his spending, but also needs to make sure it will stay that way as the years go by.
The solution
Rather than focusing only on your investment yield, first build a reasonable, diversified, low-cost portfolio without considering the yield. Then, when it comes time to spend from that portfolio, use a combination of income and tax-efficient selling of assets to fund your retirement-spending needs.
Avoid an extreme position on income in order to develop a successful investing plan.
Source: http://www.hcplive.com/physicians-money-digest/personal-finance/Dahle-4-Ways-Income-Investors-May-Get-it-Wrong