Are you looking to retire? Need income? Investors are often concerned with how much yield or income an investment can generate. Retirees want to invest money and be able to live off of the income that their investments generate. Often as investors reach retirement age, they want less risk and don’t want to ride the volatility wave of the stock market, particularly with the recent experience and pain of the 2008 recession. That pain is so memorable that it still plays a role in people’s willingness to take risk. How does this impact a portfolio? “Less risk” becomes synonymous with income-generating investments.
Here’s the problem with focusing purely on income-generating investments…Prevailing interest rates will drive the current rates of respective investments. Note that prevailing rates are quite low today. During yield starved market environments investors become so desperate for yield that they will chase the very thing that they are trying to avoid…risk. When demand grows for market starved investments, the prices of these investments appreciate, which leads to further price appreciation. Investors are forced to chase even riskier investments than before. The result: risky investments with more potential volatility.
The problem is that retirees are overly concerned with the income or yield opportunity of a portfolio rather than looking at the total return opportunity. Consider two portfolios.
Portfolio A: Generates 3% income/yield; and a total return of 5%
Portfolio B: Generates 1% income/yield; and a total return of 7%
The income-focused investor will choose Portfolio A due to an annual income that is three times larger than Portfolio B. Here’s the problem with this choice. Not only did the investor make 2% less on an absolute basis, but the investor made considerably less after taxes.
Income doesn’t matter. It is a marketing tool. We shouldn’t care about yield or income. We should only care about our bottom line; or what actually hits our pocket book.
Contributed by Daren Shavell, CFA