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Total Return vs. Income Investing

By Dr. Gerald House

WED MAR 03, 2021

Total Return vs. Income Investing

The idea that income investing can make your portfolio less diversified is a statement often proclaimed by many financial advisors. These advisors will point out that income investing is the same as total return investing but with less growth. The opponents of income investing state that one gives up control of revenue if you build a portfolio of stocks that only generates income because the dividends are not absolute; their distribution depends solely on the board of directors' decisions. However, these advisors have not plugged in the total equation. Moreover, they often neglect several advantages of income investing.

First, diversification also means diversifying the types of stocks one uses to build an investment portfolio, including investing in income stocks and total return stocks. Harry Markowitz' based his Modern Portfolio Theory (MPT) on the premise of minimizing investment risks within the investment portfolio by enhancing diversification strategies designed to optimize an investment portfolio given any level of risk. According to Markowitz, it is necessary to include investments that have an inverse relationship to each other, or dissimilar correlation to existing securities, to improve the portfolio gains and minimize the overall risks to the investment assets (Markowitz 1952). If an investor concentrates only on dividend stocks, like some pre-retirees, they are using this as a strategy to increase income for their expected retirement. Dividend-paying stocks, especially those stocks with a long history of paying dividends, are typically less volatile than growth stocks which reinvest their surplus cash into growing their company. Seniors will accept less growth for the safety and protection of their investment portfolio. Suggesting that one only invest towards building assets (total return investing) and not income for retirement is a faulty belief system. Consider the statistic that only 48% of households in the United States had some form of retirement assets set-aside in 2013 with a median value of only $109,000 (U.S. Accountability Office, 2015). Income investing, using a diversified investment portfolio, including alternative investments like direct real estate, should be the primary concern for all investors wanting to replace current income. Investors should build income early in the investment cycle to improve the stability of future income.

Second, the idea of income investing producing less growth ignores the reinvestment of dividends, especially in the accumulation years. In the book The Single Best Investment—Creating Wealth with Dividend Growth, Lowell Miller called dividend reinvesting The Eight Wonder (Miller, 2006). What he is referring to is the magic of compounding. Dividends reinvested generate a multiple compounding effect. Not only are you taking advantage of the interest (dividend) the stock paid out, but you are also increasing your holdings each year, compounding the interest every year. For instance, if you purchase a 10-year bond earning 10%, the interest earned each year is $100 with a total return over ten years of $1000. Conversely, if you invested $1000 in a good company stock earning an annual dividend of 10%, in 10 years, you will have made $2594 (Miller, 2006). Naturally, this example ignores the stock market sequence of returns concerning volatility, but it is a good representation of the compounding growth dividends offer. In his book The Case for Dividend Growth Investing in a Post-Crisis World, David Bahnsen admits that even boring utility stocks, considering the reinvestment of dividends, can often compete with technology stocks over a long investment horizon (Bahnsen, 2019).

Similarly, a dividend reinvestment plan (DRIP) takes advantage of a down market by capitalizing on the underlying asset volatility by purchasing additional shares at the lower price points. The argument that the stock price is reduced as a dividend is paid is only an urban legend. Yes, the book value of the stock is lowered, but the stock price does not adjust to reflect the total dividend paid out. Critics are quick to point out the dividends, like interest earned, create an additional tax burden. However, they ignore the increase in the stock's cost basis, thus decreasing the tax on the eventual sale of the stock holding.

As for the stock return volatility, investing in stable shares of dividend stocks proves to be less volatile than the overall market. During the last financial crisis, dividend aristocrat stocks held their own while continuing to pay dividends. Johnson & Johnson, Chevron, and PepsiCo even raised their dividends (Dividend Growth Investor 2014). Conducting a thorough analysis of the stock's underlying value is always a prerequisite before investing in a company. Investing in high-yield dividend stocks is not always in your best interest if the company's core values are weak. According to the study conducted by Auxilia & Krithika (2018), the top high yield dividend stocks value from January 2011 to January 2015 depreciated 31%, even considering the dividend amount. The authors found little difference in the value of high yield dividend portfolios and non-dividend stocks. An investor should look for good stable companies paying consistent dividends—the fundamentals of a company matter. Always do your homework on the company's background, the track record of paying dividends, and the growth potential before committing to the investment.

References

Auxilia, P. M., & Krithika, J. (2018). A Study on the Investment Performance of High Dividend Yield Stocks With Reference To Nifty. Journal of Economics and Finance, 9(1), 67-74. doi:10.9790/5933-0901016774

Bahnsen, D. L. (2019). The case for dividend growth: Investing in a post-crisis world. New York, NY: Post Hill Press.

Dividend Growth Investor (2014). Dividend investing during the financial crisis. Retrieved March 02, 2021, from https://seekingalpha.com/article/2213413-dividend-investing-during-the-financial-crisis

Markowitz, H. M. (1952). Portfolio selection. The Journal of Finance, 7, 77–91. doi:10.2307/2975974

Miller, L. (2006). The single best investment: Creating wealth with dividend growth. Bearsville, NY: Print Project.

U.S. Government Accountability Office, GAO-15-419 Retirement Savings. (2015). Retirement security, most households approaching retirement have low savings: Report to the Ranking Member, Subcommittee on Primary Health and Retirement Security, Committee on Health, Education, Labor, and Pensions, U.S. Senate 1-51. Washington, DC: United States Government Accountability Office.

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