Generating Income And Limiting Risk - Strategies To Create A Balanced Portfolio And Boost Income

by: Matthew Utesch

Rebalancing a portfolio is something that we all have to do. The question is, how do we know when we are supposed to do it?

Comparing positions relative to the total size of your portfolio is only half of the equation.

It is also important to compare income generated by a position relative to the total income generated by a portfolio.

In this article, we discuss risk tolerance and look at how adding some high-yield equities can add extra income without moving too far outside of our comfort zone.

Investment Thesis

Everyone who invests knows that it is incredibly important to decide what level of risk they are willing to take in order to generate the return that they want. When we think of risk, we tend to think of it based on the type of financial instrument (cash, bond, equity, etc.), but it is important to remember that the risk continues to break down from there because not all bonds or equities are created equal. Generally speaking, the image below offers a generic view of the risk/reward that tends to follow some of the investment options we have the option of using.

Source: XTB - Risk vs Return of Investment Types

A well-rounded portfolio should have elements of these types of investments like certificates of deposit, bonds, and equities. It is within each of these groups that we can begin to truly assess the risk a specific investment on the portfolio.

So, how do we decide how much risk we are willing to accept? This is a difficult question to answer because what might represent a risk to you may not represent a risk to me. Instead of answering this question, I think there is a better question for investors to ask when approaching the construction of their portfolio:

  • What can I do to maintain reasonable returns while at the same time reduce the risk of downside in my investment portfolio?

After years of investing and making mistakes, this question is what ultimately compelled me to become a Dividend Growth Investor or a DGI (I will also refer to this as DG). The goal of this article is to explore the idea of being a DGI and why it is an effective method for overcoming risk. I want to also offer readers' some easy solutions that will help them assess the risk in their portfolio and what they can do to combat it.

Why I Chose Dividend Growth Investing

There are many reasons for being a DGI and everyone who subscribes to the model has their own personal convictions for choosing it. Personally, I find the DG model to be so compelling because of the following two reasons:

  1. If you choose to invest in the best dividend-paying companies you will always have a paycheck regardless of market conditions.
  2. Historically speaking, companies that consistently grew dividends saw the greatest average returns from the beginning of 1972 to the end of 2017.

Retirees who do not have a pension plan tend to look at their retirement based on the total dollar amount available if they were to liquidate their holdings. The classic rule of 4% is another way I have seen the average person explain their retirement because it is a simple way of understanding what can potentially be a large number. In reality, the 4% rule is unrealistic as large market swings can create major fluctuations in portfolio balances. This method places too much emphasis on the total balance of their portfolio as they expect they will need to draw down the balance of this account over the remaining years of their life.

This method is inherently risky based on the fact that we are expecting the market will provide optimal returns during this time frame. A simple analogy for this situation is to think of your retirement fund as a job where the pay comes in the form of a small salary/wage with a bonus that varies drastically based on how the company performs.

The DG methodology takes the opposite approach because these investors are more concerned about the consistency of their paycheck which comes in the form of interest, dividends, and distributions. For the DGI, they are rather unconcerned about the total value of the account and are more concerned with making sure they are invested in companies that offer products and services that will keep them in business (through the good times and bad). When thinking about the DGI model it would be comparable to taking a salaried job with an optional/smaller bonus at the end of the year that can vary depending on how the company does.

When we begin to view our portfolios from these two paradigms we can begin to understand why the first scenario (small wage and unpredictable small/large bonus) is an extreme risk to a retiree's well-being. The second scenario offers a reasonable level of predictability because of the consistency for the best companies to pay out increasing dividends year-after-year which makes it a more promising choice for the investor who is looking to reduce risk.

For those of you who are number people, I want to drive the point home by looking at some hypothetical figures for a DGI named John.

John's DGI Portfolio - Example Scenarios

In this scenario, I am using John as a hypothetical example of a person who has saved a significant nest egg and running his DGI portfolio through two scenarios spanning the range of 2000-2009 (a poor decade of returns) and 2007-2016 (considered to be a much better decade of returns). Here are the main details of this hypothetical scenario:

  • John $1,000,000 in retirement funds and are all invested in dividend growth stocks.
  • John subscribes collects all dividends as cash.
  • When the market has a positive return he takes a set bonus of $20,000 (scenario one) and a $40,000 bonus (scenario two).
  • When the market has a negative return he takes no bonus and continues to use his dividends as his sole source of income.
  • John's base wage (remember, the wage represents interest, dividends, and distributions) and starts at $50,000 and increases 5% annually (assumes an average dividend growth rate of 5%).

Now, we also need to make some assumptions about the scenario because it is too difficult to control for every minute detail. In this scenario we are assuming the following:

  1. The growth/decline for the year is the total impact on capital appreciation. The dividend is excluded from this figure since John is collecting it as cash.
  2. The dividend is assumed to remain stable and growing (for instance, no cuts in 2008 during a major downturn).
  3. All "bonus" withdrawals are coming at the very end of the year after the gain on the portfolio has been accounted for.
  4. The beginning dividend payments of $50k are based on a 5% yield on $1,000,000. This income stays the same (plus 5% annual growth going forward) regardless of how the market performs (AKA, the new yield for each following year is not based on 5% of the new portfolio balance).
  5. Portfolio growth figures are based on the returns of the S&P 500.

John's DGI Portfolio - Scenario One

I was most interested to see how a DGI portfolio would've performed from 2000-2009 if we applied the bullet points that dictates John's approach. I consider the 2000-2009 time frame to represent a period with greater risk given the average portfolio growth during that decade was approximately 1.2%.

I have used the time period of 2000-2009 because it represents situation where it is extremely difficult to try and build a portfolio that generates solid capital appreciation. Any time we use a historical period where the starting years are represented by losses (in this case, the first three years represent major losses) it will always create a significant setback to the example at hand. In John's case, these years of setback only had an impact on his bonus because the stocks he bought into continued to pay increasing dividends during those three years (for any naysayers out there, there were plenty of companies that did this). Once the market recovered, John was able to continue enjoying his growing dividends while simultaneously drawing a bonus check of $20,000/year during the "good times".

Even in this poor return scenario, John's DGI portfolio produced the following results:

  • An average wage income of approximately $62,900/year.
  • An average bonus income of approximately $12,000/year.
  • An average total income of approximately $74,900/year.

Not too bad for a decade with average capital appreciation of 1.2%, right?

Had we continued with this scenario into the years of second phase in the next section, we would have seen John's account make a significant recovery that would have eventually exceeded his $1,000,000 starting position even after accounting for his $20k annual bonuses.

John's DGI Portfolio - Scenario Two

In the second scenario, I explored the following questions:

  • What happens when a DGI portfolio goes through a period of solid returns?
  • Will a DGI portfolio offer enough growth for a DGI's taste?
  • Since times are so good, what if the bonus in this scenario increases from $20,000/year to $40,000/year?

This time frame runs from 2007-2016 and uses the same assumptions as the first scenario (with the exception of an increased bonus).

During this time frame, the average annualized portfolio growth was approximately 8.8% (I consider this to represent a strong decade of growth) and there was only one year (2008) where John did not receive his $40,000 bonus on top of his normal "wage". Although this decade produced strong results it is not an overly optimistic time frame because it takes into account the -37% loss in 2008 (and remember, the earlier the hit the harder it is to recover. John's portfolio would've produced the following results:

  • An average wage income of approximately $62,900/year.
  • An average bonus income of approximately $36,000/year.
  • An average total income of approximately $98,800/year.

It's also interesting when we consider that John's income increases at the same pace as it did in the first scenario

Investor Takeaway From John's Scenarios

The purpose of a DGI portfolio is to remove risk regardless of whether the market is declining or rallying (as shown in the two scenarios above) by providing a steady stream of income that is necessary for a retiree to feel stable. By adopting this method, we are reducing the chance that we will need to time the market by having to sell equities when we need the income. Timing the market when building an investment portfolio is difficult (if not impossible) but it is even worse to have spent your life accumulating wealth only to bet that the market will continue to have "good years" as the main source of certainty in retirement. Needless to say, betting on capital appreciation and positive stock gains represents a significant risk to the long-term balance of an investment portfolio.

Chart ^DJI data by YCharts

Consider this observation about the above chart regarding an investor who dependent on their bonus as a major source of retirement income and who is waiting to withdraw their "bonus" until the end of the year:

  • If the portfolio is primarily composed of stocks in the DJIA the investors would be losing -$.142 for every dollar they withdraw from their investment portfolio. (Compared to having sold stocks and withdrawn funds on October 1st, 2018).
  • If the portfolio is primarily composed of stocks in the S&P 500 the investors would be losing -$.156 for every dollar they withdraw from their investment portfolio. (Compared to having sold stocks and withdrawn funds on October 1st, 2018).
  • If the portfolio is primarily composed of stocks in the NASDAQ Composite the investors would be losing -$.188 for every dollar they withdraw from their investment portfolio. (Compared to having sold stocks and withdrawn funds on October 1st, 2018).

Here is another way to think about the information above:

First of all, I won't try and pretend that the losses from October 1st to December 21st were avoidable (we can't avoid this drop in value assuming the portfolio composition is the same in both scenarios). However, what we can acknowledge is that the highlighted column represents the amount that is costing the investor because they are withdrawing money that has since been devalued.

With these figures in mind, who in the normal work-world would ever consider a job with almost no regular wage but the potential for a large bonus at the end of the year. Sure, some may agree to a plan like this if they are working for a startup but that validates our premise that a person who signs up for that plan is agreeing to the risk because they see the potential reward. For a retiree, this risk is unacceptable because there is no do-over button that is offered to us when we reach retirement. A DGI portfolio represents an easy method for maintaining a balance between "wages" and "bonuses" (which again) helps reduce risk tremendously.

Defining What Risk Means To You

When I am looking at my clients' retirement portfolios I'm constantly considering the various risks (existing and potential) that could have a real impact on their retirement portfolio. I tend to think of risk as something that can derail my clients' from achieving their goals which is why it is important to understand that only can you determine the risks if you know what the clients' hopes, dreams, and goals are. Here is an example of a simple goal but viewed through three different perspectives:

  • Client A - Wants to buy a home in Arizona and pay for it entirely with cash upfront (no payments).
  • Client B - Wants to buy a home in Arizona and is open to paying a combination of cash upfront and financing the rest.
  • Client C - Want to rent a home in Arizona and has no intention of buying.

Although all three clients' want to have a home in Arizona, all three of them have a different perspective as to how they would like to achieve that goal.

Ironically, I believe that client A's request represents the most risk because they have decided that payments are something they don't want and will need the cash upfront. Therefore, we will need to make sure that we will need to set aside these funds in the safest possible investment (like a CD) since any major market fluctuations could have a significant impact on the overall value of their portfolio. In other words, it doesn't take much for a $250,000 home to cost $300,000 because the funds being used to purchase it has declined in value due to unfavorable market conditions. As such, these types of scenarios will impact how much cash flow the client will need in order to sustain the lifestyle they want to live.

It is important to reiterate that there is no scenario were absolutely no risk exists and so DGIs must be realistic in their expectations. After all, if Client A is unwilling to budge on their desire for no payments then they must also be willing to accept that their monthly "wage" will be lower since funds for this home in Arizona will likely be placed in a short-term CD with no capital appreciation and a minimal dividend/interest paid.

Measuring Risk In My Clients' Taxable Portfolio

We have established so far that investments carry risk but what about the risk of composition in a portfolio? I am not referring to the mixture of investment types (bonds, stocks, etc.) as much as I am looking at each specific investment type and the number of individual positions that results in 100% of the total market value associated with each specific investment type.

The type of risk in a portfolio comes in two forms:

  1. The size of a position relative to the total value of the portfolio.
  2. The amount of income relative to the total income of the portfolio.

It can be a major risk to have too much exposure to a single company regardless of the size of your portfolio. The size of a position and the amount of income it generates can have dire consequences on a DGI's portfolio in the event that the dividend is cut, eliminated, or the company folds. Unfortunately, many investors who have not saved enough to adequately meet their retirement needs end up relying on these types of investments to provide a significant portion of the income they need. While high-yield investments can be helpful to boost income, investors should make sure that their total exposure to any single high-yield investment remains limited.

Since it is the end of the year, I wanted to take a look at my clients' John and Jane's Taxable portfolio to see if there are any positions that are responsible for too much of the total portfolio's value or income. Disclaimer: The figures shown below represent a real portfolio that I manage for my clients. This article is not intended to serve as advice and is for informational purposes only. It is important that you do your own research and create a portfolio that meets your investment needs!

For clarification, some of the information in the table below is derived from my Taxable Account Tracker that is used in my John & Jane series.

The table above is color-coded to show the following:

  • Green = % of income or % of total market value between 0%-3%
  • Yellow = % of income or % of total market value between 3.01%-5%
  • Red = % of income or % of total market value 5% or greater.

The purpose of these colors is to help the investor identify whether or not a specific position makes up too much of their total portfolio (in this case, I use market value) and if the income generated by that position represents too much of the total portfolio income.

Here are some general observations that I found interesting:

  • Only one position exceeds my 5% market value limitation and it is Eaton Vance Floating-Rate Advantage Fund A (EAFAX) which isn't a major problem because it is composed of primarily senior secured bank loans. These loans are typically below investment grade and have floating rate tied to LIBOR. As such, interest payments received should continue to increase although the risk of a loan going bad is also increased.
  • Positions with a total market value of 3.01%-5% are primarily composed of large companies that are well-known and who have entrenched business models. Some examples of this include Verizon (VZ), Simon Property Group (SPG), Altria (MO), Clorox (CLX), and Apple (NASDAQ:AAPL).
  • ORI currently shows that it was responsible for 6.36% of the income generated in the 2018 Taxable Portfolio. This is largely due to the special dividend of $1.00/share that was paid in January of 2018 and more than doubled its effective dividend yield. If we remove this special payment then we see ORI is right in line with where we would expect it to be, based on its current dividend of $.195/share per quarter.
  • The high-quality positions that tend to make up a large amount of the total market value typically generate a low-to-modest amount of total income. Small positions with higher yields are used sparingly to boost yield. A good example of equities like this from the list that fit this description includes Energy Transfer (ET) and Arbor Realty (ABR).


When I look at the portfolio using the income generated from 2018 I can say that I am comfortable with the current standing of their equity positions. Most of the market value exposure is rooted in companies with strong business models and have a reason to exist. At the same time, we have included small positions in some equities that I would consider slightly risky because they increase the income generated significantly even though they represent only a small amount of the total market value. I believe that John and Jane's portfolio composition (market value and income) looks solid from a 2018 perspective.

In the near future, I will be using the same analysis to determine how the portfolio looks based on 2019 dividend estimates. One of the problems with looking backward is that a number of companies that were added in the last 2-3 months of 2018 did not generate a meaningful amount of income. This includes:

  • Legget & Platt (LEG)
  • Phillips 66 Partners (PSXP)
  • Schlumberger (SLB)
  • United Technologies (UTX)

My 2019 analysis will be based on FY-2019 dividend estimates that will provide a more accurate assessment of how the portfolio is positioned and the market value/income risk in 2019.

Given the recent turbulence in the market, we have been focusing on adding high-quality equities to John and Jane's Taxable Portfolio because there are stocks offering dividend yields that haven't been available for more than a year. At this point, John and Jane's portfolio has enough risk associated with it and we are not attempting to boost the yield more than we already have. In this sense, we have found the "sweet spot" concerning the % of total market value and % of total income.

In John and Jane's Taxable account, they are currently long the following mentioned in this article: Apple (NASDAQ: AAPL), Arbor Realty (ABR), Archer Daniels Midland (ADM), Apple REIT (APLE), BP (BP), Buckeye Partners (BPL), Cardinal Health (CAH), Clorox (CLX), Cummins (CMI), Eaton Vance Floating-Rate Advantage Fund A (EAFAX), Emerson Electric (EMR), EPR Properties (EPR), Energy Transfer (ET), General Mills (GIS), Helmerich & Payne (HP), Hormel (HRL), Iron Mountain (IRM), Johnson Controls (JCI), LTC Properties (LTC), Leggett & Platt (LEG), Macquarie Infrastructure (MIC), Altria (MO), Mesabi Trust (MSB), New Residential (NRZ), Realty Income (O), Old Republic International (ORI), Phillips 66 Partners (PSXP), Spectra Energy Partners (SEP), J.M. Smucker (SJM), Tanger Factory Outlet Centers (SKT), Schlumberger Limited (SLB), Southern Corp. (SO), Simon Property Group (SPG), Schwab Value Advantage Money Fund (SWVXX), AT&T (T), Texas Instruments (TXN), United Technologies (UTX), Verizon (VZ), Washington Trust (WASH), Westlake Chemical, W.P. Carey (WPC), and Exxon Mobil (XOM).

Disclosure: I am/we are long GIS, T. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article reflects my own personal views and is not meant to be taken as investment advice. It is recommended that you do your own research. This article was written on my own and does not reflect the views or opinions of my employer.