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According to Investopedia, Modern Portfolio Theory (MPT) is defined as follows:

A theory on how risk-averse investors can construct portfolios to optimize or maximize expected [total] return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward.

I've been thinking that it's time we developed a parallel Modern Income Theory. Part of that would be a Modern Dividend Theory (MDT). I am going to restrict myself to the latter, because it is my area of expertise.

I am going to try to start off developing this theory by comparing MPT concepts to analogous MDT concepts. The MDT concepts are hyptheses, but then again so are most MPT concepts.

As you read through the following, you will notice significant contrasts, starting right off with the underlying goals themselves. I think this is why MPT proponents have difficulty even talking to MDT proponents, because the goals and tenets are so different.

In the chart below, "return" on the MPT side means total return unless otherwise noted. "Return" on the MDT side means dividend return unless otherwise noted. Also, I use "dividend" broadly to refer to common dividends, preferred dividends, and distributions by such entities as MLPs and REITs.

Tenet

Modern Portfolio Theory

Modern Dividend Theory

Primary goal

Maximize expected total return with least acceptable risk. Little to no emphasis placed on income.

Maximize dividend income with least risk. Some emphasis also placed on total return. Some investors' primary goal is total return using income-investing techniques.

Significant metrics

Total returns; CAGR (compound annual growth rate); risk (standard deviation from expected mean); total wealth.

Dividend income; DGR (compound annual growth rate in dividends); total income.

Significance of income

Secondary.

Central.

Risk measured by

Volatility or standard deviation from the mean in total return.

Unexpected reductions in dividend stream.

Can there be negative return?

Yes. Actual value of portfolio may go up or down.

Not in dividend stream. There is no such thing as a negative dividend. However, value of underlying portfolio can go up or down.

Risk-reward

tradeoff

Low risk is associated with low potential total returns; high risk is associated with high potential returns. Higher returns can only be achieved by assuming higher risk (i.e., higher volatility).

High and growing dividend streams can be achieved with relatively low risk. There is no consistent relationship between risk levels of total returns and risk levels of dividends. Indeed, dividends can rise while total returns are falling.

Diversifica-tion

By investing in more than one stock, investor can reap benefits of diversification-chief among them, a reduction in the riskiness of the portfolio.

Same. (Note that the "riskiness" referred to here is risk to the dividend stream, while in MPT it refers to risk in total returns.)

Correlation

The difference between different assets' levels of risk determines overall portfolio risk. Investing in uncorrelated asset classes in varying proportions determines both risk and potential total returns.

Results are achieved with single asset class-dividend and distribution stocks. Some investors would classify distribution instruments such as REITs and MLPs as different asset classes.

Steadiness of returns

Total returns move up and down as asset prices move up and down in the markets.

Dividend stream moves generally upward as companies increase dividends. Dividends are not market-dependent.

Optimal number of asset classes

Varies depending on pundit. Most common recognized classes are stocks (of various flavors) and bonds (of various flavors). Some other asset classes-such as real estate and "alternative" investments-are often considered to be legitimate (i.e. non-correlated) asset classes.

Uses single asset class, namely dividend and distribution stocks of various flavors: Common stocks; preferred stocks; REITs; MLPs; BDCs. Asset classes without significant distributions are not involved in the strategy.

Proportions in which to hold asset classes

Varies by pundit.

Same.

Common word to describe portfolio construction

"Exposure," meaning to expose yourself to various risky assets. Exposure to risk also exposes investor to potential rewards.

"Opportunity," meaning to avail yourself of opportunities to create positive dividend streams.

Passive or active?

Passive. Investor selects target proportions for various asset classes, then rebalances periodically to restore proportions to original targets. Individual stocks are not purchased, rather ETFs, which are then held with only activity being rebalancing. (ETFs themselves, of course, hold and trade individual stocks and bonds.)

Active. Investor selects stocks initially, then monitors them for continued satisfactory performance. Investor may rebalance if (say) sector proportions get out of whack. Investor may sell or replace stocks under defined circumstances to maintain or increase dividend stream.

Buy individual stocks?

No.

Yes.

Selected sources:

  1. Investopedia, definition of "modern portfolio theory."
  2. Modern Portfolio Theory: Why It's Still Hip, Investopedia, written by Ben McClure (January 7, 2010)

Disclaimer: This article is only meant to scratch the surface between investing for total returns compared to investing for income. My main goal here is to propose that just as total-return seekers have theoretical support in MPT, income-seekers have theoretical support in MDT, which at some point could be expanded out to MIT, meaning "modern income theory.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Continue to Part 2 >>

Source: Modern Dividend Theory Explained Part 1