This week's topic comes courtesy of Double Dividend Stocks: In the tug-of-war between income vs. capital gains, how does an income-oriented investor balance the two?
In their recent article, "Income Vs. Capital Gains: A 7-8% Quest," DDS wrote:
There comes a time for many investors when they make the switch from targeting capital gains to generating income from their portfolio. This transition brings up many conundrums and issues to ponder, such as your yearly returns vs. those of the market.
In 2017, the Dow had a 25% return and the S&P had a 19.4%% return, dwarfing the returns of many dividend-rich sectors, such as utilities, real estate, energy and telecoms, which found themselves on the bottom of the heap:
On a personal level, each investor decides their needs, and, hopefully, goes with what works best for them. A 30-something can take on more risk due to their longer investment period vs. someone in their 60s, who is retired. If you're meeting your annual investment income target, should you care whether or not your returns lag the market in a rip-roaring year?
For their Marketplace Service, Hidden Dividend Stocks Plus, DDS focuses on dividend and distribution coverage ratios. "Chasing higher yields that aren't backed up by adequate cash flow can often lead to losses, no matter how high the yield is," DDS explained in their recent article. "Rather than focusing on capital gains and hitting home runs, we establish portfolios that produce a target income for an account. We also seek out income vehicles which may be good places to weather a market storm."
We asked several of our other contributors to weigh in with their thoughts about the income-capital gains balance. Here's what they had to say.
As an income investor, one of the last things in the world you want is to be forced to sell your holdings at fire sale prices, as was the case for many investors just nine short years ago during the depths of the financial crisis. And it is for that exact reason that so many investors strongly prefer to rely on safe dividend income from reliable blue chip companies that can be trusted to keep making those payments during both good times and bad.
Arguably, there are advantages to relying on selling some of your winners (capital gains) to generate a portion of the income you need (such as diversification and more control over your taxes). But when the stuff hits the fan, all correlations move towards one, diversification doesn’t deliver the benefits you need when you need them the most, and once again you’re stuck in the undesirable situation of being forced to sell some of your holdings at fire sale prices - yuck!
Every investor’s situation is unique, and there is no one-size-fits-all solution to the question of how to balance income versus capital gains, but the best thing you can do is to proactively devise a plan to meet your own individual needs so you’re not scrambling in a reactive fashion the next time the market sells off - even if it’s just an 8-10% sell-off like we’ve experienced over the last two weeks.
One of the things I try to do within my Marketplace service, The Value & Income Forum, is to provide investors with a steady flow of exceptional new income-focused investment ideas so they can structure their own personal portfolios to meet their own personal needs. For example, just last week I provided members with a list of 100 high-yield stocks that were down big after the selloff, as well as a description of a few of the most attractive names, in this article: 100 High-Yield Stocks Down Big Last Week: These 5 Are Worth Considering.
Outside of writing about investments, I manage investment portfolios for institutions and individuals ranging from safe high income to aggressive capital appreciation. And the question of how an investor can balance capital gains versus income is very different for every account. However, what’s the same for everyone is that no one wants to be forced to sell their holdings at fire sale prices just to meet their regular living expense. Have a plan, and stick to it, so when the stuff hits the fan, you can still sleep well at night.
In a nutshell, I believe it's a matter of portfolio allocation and diversification. By modulating equities, fixed income investments, and cash, a given investor can “dial up” a happy blend of income and capital gains. A corollary to the thesis is avoiding the temptation to chase yield.
First, a clear portfolio allocation model is required. Let's say a “typical” baseline investor favors a 70-20-10 model - meaning a portfolio constructed of 70% equities, 20% fixed income, and 10% cash. What kind of income may be offered from this?
In today's market, equities may be expected to yield between 2% and 3%. Reliable fixed income is likely to produce between 3% and 4%. Cash is not likely to offer more than 1%.
Accepting these benchmarks, the subject portfolio should provide annual income between ~2.1% and ~3.0%.
A conservative equity portfolio should offer net capital gains averaging 4% or 5% a year. Expectations for gains associated with fixed income or cash investments may be nil.
Given the aforementioned data points, income investors can adjust stock/fixed income/cash allocations accordingly. It's an arithmetic exercise.
Of course, there are caveats, and this gets to the crux of the question.
Unquestionably, the current investment environment makes developing the income part of the portfolio somewhat challenging. Generally, today's income investors find themselves hard-pressed to obtain sufficient yield. Such individuals face a “double-whammy:” historically low fixed income/cash yields coupled with the real prospect of higher interest rates.
No matter. Good investors know they may only take what Mr. Market offers.
Investors who chase yield do so at their own peril. Reaching for yield above what the market offers is at best a risky proposition, and at worse downright dangerous. Why? Attempting to generate above-market income subjects the investor to significant capital destruction. Generate more yield with riskier high-yield stocks, then watch the stock crater on a dividend cut? Go long on fixed income to pick up greater interest income, then risk the inverse-correlation between yield and underlying principal? No, income investors seek capital preservation.
What to do? Diversification is the only free lunch in town.
The equity component of the portfolio may emphasize better-yielding utilities and consumer staples stocks. However, a measure of sector diversification, perhaps via carefully selected Dividend Aristocrats, is in order. The best income investors avoid the trap of focusing solely upon high dividend yield versus demonstrated dividend growth. Levered up mREITs and poorly capitalized MLPs may provide immediate income gratification, but they have the propensity to lead to some very long faces afterwards.
Meanwhile, sound fixed income thinking concentrates upon capital preservation versus the pursuit of high yield. Investment-grade bonds, held to maturity, represent a solid foundation. TIPS may be a reasonable choice. Chasing up sub-investment-grade bonds or levered ETFs for an extra couple hundred bps? Not so much.
Finally, for income investors, cash remains ballast in the ship. Sure, income is weak, but capital preservation is outstanding. Never overlook the value of a set of well-laddered CDs and a modest pot of liquid cash.
Balancing income and capital gains is really an individual choice. It has to fit your own personal risk profile. The real question is how much of what the portfolio earns is spent. You have to be particularly careful when some of that income is really a return of capital. Return of capital may have to be reinvested. There are some very good traders out there, and others are good at buy and hold. The individual investor must do what is right for them.
A young investor may go for more trading and more risky income choices that also yield capital gains. But after a pullback like we have had (and it may continue), there are going to be some high-quality income issues offering capital gains. So there is really not a hard and fast rule. In the market, it is a moving target. Also, if your income stream becomes overvalued, do you have the nerve to sell it and wait out the overvaluation period or do you hang on and ride that stream forever?
So much depends upon the person investing.
Investors should not focus too much on dividend yields, particularly when they are young. For instance, many investors were lured in by the 10% dividend yield of Seadrill (SDRL) when the price of oil began to plunge, almost four years ago. Unfortunately, the dividend of the stock proved negligible compared to the capital losses, as the stock has essentially gone to zero. Whenever a stock offers a higher-than-5% dividend yield, investors should make sure they understand the reason behind the high yield.
The above example shows the risk of focusing too much on the income stream. Of course, the ultimate goal of all the investors, even those who are young, is to build a portfolio that will be generating a satisfactory income stream at some point in the future. Nevertheless, the best way to achieve this is to ignore the income stream in the short term and focus on it only a few years before retirement. At that point, investors can replace their low-yield holdings with stocks and bonds that will be offering a satisfactory yield. I repeat because this is the most important point: Focus only on capital gains while you are far from retirement and shift your focus on your income stream when you approach retirement.
In order to achieve their retirement goal, investors should purchase a low-fee index ETF or do exhaustive due diligence to select the stocks that have the most promising growth prospects and minimum debt load. If they choose their stocks based on their dividend yield and their dividend growth record, they will position themselves for plenty of negative surprises. The shareholders of Kinder Morgan (KMI) have learned this lesson well. They bought the stock for its generous dividend and failed to notice that the debt load and the payout ratio were excessive. Consequently, the shareholders incurred a 75% dividend cut about two years ago. Even worse, the stock lost 65% in the few months before it cut its dividend. Therefore, those who focused on the high dividend yield eventually lost dividends of several years.
Regarding my portfolio, thanks to the ongoing bull market and my moderate leverage, my portfolio has increased 6-fold in the last 6 years. As a result, I am only about 25% away from my retirement goal and I am only 42 years old. I achieved this by focusing on the growth prospects of my stocks while I completely ignored their dividend yield. Nevertheless, now that I have come closer to my retirement goal, I have focused on the income stream of my portfolio. Therefore, as I consider S&P fully valued at the moment, I only own corporate bonds, which yield about 6% per year, and short positions in put options of solid stocks. My annual income stream is already sufficient for the needs of my family, but I have decided to keep working and let the income stream grow via reinvestment for many more years.
Despite the recent selloff in U.S. equities, the S&P 500 (SPX) is still up 13% over the past 12 months and 72% over the past five years. When markets demonstrate strong trending moves, it can be easy for income investors to take their eye off the ball with their income investments. However, with markets at all-time highs, now is the most crucial time for effective portfolio management. Finding quality dividend-paying stocks with strong competitive advantages at attractive valuations is much more difficult now than 5 years ago, for example.
Reducing the cost basis of shares is imperative and is mainly done by reinvesting the portfolio's dividends back into the respective underlyings. Furthermore, the recent spike in volatility gives the investor the opportunity to sell covered calls on some on their positions. A covered call trade (although capping upside) is still a bullish trade and in periods of high volatility can really generate excellent returns for the income-minded investor.
However, back to the original question: How can income investors balance income and capital gains? I would recommend using something like a trailing stop on the capital gains side of the portfolio to protect gains. Pure cash-flow investors though do not mind where the market is trading as income is the goal. Don't try to deviate from this mentality much. Yes, capital gains can be a small piece of one's portfolio at present, but investing in this way should be done with caution and prudence. Markets are cyclical. Eventually, the bull market will come to an end, which is why true cash-flow investors excel in every type of market condition. Yes, in strong trending markets, collecting income may be boring, especially when you see something like a tech stock really outperforming. Don't let market conditions derail you too much from your core strategy. This too shall pass.
Now it's your turn. How do capital gains fit into your income goals (or vice versa)? Please comment below!
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Finally, here's some recent Dividends & Income content you might want to check out (if you haven't already):
Dividend Champions Raise Dividends, That's Why They're Dividend Champions by Colorado Wealth Management Fund
Profit From ETFs Selling This High-Quality REIT by WideAlpha
CBL Properties: You Can't Fool Me Twice by Julian Lin
Apartment REITs: A Battle Of Supply And Demand by Hoya Capital Real Estate
How To Overcome Your Fear Of Bonds by Cullen Roche
The Stars Have Lined Up For A Dividend Cut by Brad Thomas
Realty Income: Risk Premium Perspective (And Bond Math) by David C. Kim
Realty Income: Fraudulent Value Trap Or Good Long-Term Buying Opportunity? by Dividend Sensei
Using Personal Math Instead Of Abstract Theory To Make Better Retirement Decisions by Daniel Amerman, CFA
Construct A Crash-Resistant Income Portfolio by Financially Free Investor
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.