One of the most-discussed issues in long-term investing is whether to focus on income generation or simply to think in term of total return (price gains plus income). The discussion of this topic often focuses on whether investors should seek out stocks that pay dividends vs. simply planning to sell a fraction of their portfolio periodically to provide income. I recently wrote a long article on this topic, which has been cited in a very interesting discussion of this theme going on at Bogleheads. One of the most active participants in the debate on the Bogleheads forum and elsewhere is Larry Swedroe, a well-known advisor and author. As I read the Bogleheads discussion thread, it strikes me that there is considerable confusion around this topic, so I thought I would add a few more thoughts.
The debate over income vs. total return investing is especially important to people who are in retirement and who depend on an income stream from their portfolios. If you can live entirely on the dividends, bond yield, and other distributions from your portfolio, you don’t have to worry about longevity risk—the risk of depleting your portfolio in your lifetime. This is probably the major appeal of income investing. There are many who believe that an income-focused strategy is a mistake, however, and Swedroe has written a number of articles in which he asserts this. Vanguard has also published research in which they assert that total return strategies are superior to income-focused portfolios. Here is an article in which I analyze Vanguard’s case.
The arguments in favor of a total return focus are, in my appraisal, holding sway in the money management industry for the time being.
To understand this issue, I like to think in terms of a metaphor to another type of investing. Imagine that you purchase a ski condo for the purpose of renting it out for income. You have two sources of return from this investment. You have the rental income and you have the potential to benefit from an increase in real estate values over the period that you own the condo. You might purchase a condo in an area in which you need the entire rental income to cover your mortgage on the condo, fees from the homeowner’s association, and maintenance and upkeep on the condo. The only way you will actually realize a positive return on this property is to eventually sell it. From the time you buy to the time you sell, the only returns you accrue are paper returns: your estimate of the future sales price of the condo. On the other hand, you might buy a condo that generates income that consistently gives you cash flow beyond all of your costs. Whether you sell or not, you are generating income. The two sources of return on your investment might average out to be the same over the lifetime of the investment, but they are undeniably different.
Dividend-paying stocks are not inherently safer than non-dividend payers. The fundamental difference between them is that dividend payers give a portion of their income back to shareholders while non-dividend payers either invest the money in growth or do share buybacks. In theory, investors should be indifferent as to whether their returns come in the form of dividend checks or reinvestment. In practice, companies that pay dividends are often less risky because their business models and management are less aggressive.
If you control for differences in risk between companies, why would someone choose to invest in stocks on the basis of dividends? The answer is actually very simple: consistency of at least some portion of the return. If a company has a long history of paying a dividend—AEP is one example that was mentioned on the Bogleheads discussion—we can feel pretty confident that it will continue to do so. Companies can and do cut their dividends when they are in distress, of course. In light of the dividend payment history for AEP (which pays four times per year—see chart below), I am quite comfortable betting on a quarterly dividend of $0.47 per share for next year. This equates to a dividend yield of 4.3% at the current price.
How confident can we be as to how much AEP’s price will go up next year? There are a variety of ways to come up with reasonable expectations for price returns from stocks, but the uncertainty with regard to the outcomes is high. We can predict quite confidently that we know how much gain we will get from dividends but we cannot predict the changes in price for AEP over the next year with any confidence at all.
This difference in the uncertainty with regard to estimating dividend return vs. price return is the key distinction of dividends. There will be some investors who judge that their ability to forecast price returns is comparable to their ability to forecast returns from dividends. For these people, dividends have no advantage. There will also be investors who are comfortable with year-to-year variability in returns and are willing to bet that the diversification benefits provided by non-income-generating assets is sufficient reward for the higher uncertainty in estimating returns. This is, in fact, a strong argument in favor of total return investing. There will also be people who place a premium on reducing their estimation uncertainty in the amount of income that a portfolio generates, and it is for these people that income investing will make the most sense.
The decision to invest for income or for total return reflects investor preferences in important ways. The ongoing debate—which sometimes seems to get pretty heated—would benefit from a balanced approach. It is not the case that income investing is inherently better or less risky than total return investing. The choice of the balance of income vs. price appreciation depends on an investor’s specific needs, risk tolerance, and level of sophistication in making investment decisions.
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