The Fallacy of the Preference for Income in Portfolios
By Joseph Zaccardi, CFA
The most challenging part of providing financial guidance to families and institutions is overcoming educational hurdles to deliver a solution that provides enough comfort to allow the power of compounding to work over the long term. The most difficult request we receive from clients is, “I would like to increase the income of my portfolio.”
At Drexel Morgan, we believe an erroneous focus on income relative to total portfolio return often leads to suboptimal outcomes that can be avoided with education and proper portfolio construction. With very few exceptions, constructing a portfolio to produce a total return that meets current and future obligations is superior to myopically focusing on income. In this article, we will focus on the technical fallacies that investors encounter when comparing total return and income. In a future piece, we plan to discuss some of the behavioral aspects that drive a preference for income.
We believe one of the reasons clients often prefer income to total return is the perceived mismatch between the cash flow from their assets and the outflow from their liabilities. A useful way to frame this problem can be found in the way corporations should analyze capital investment decisions. Simply put, the decision of whether or not to undertake a capital investment is irrelevant to the source of financing. A company should evaluate expenditures based on the net present value (NPV) of the project. If the project has a positive NPV, then the company should explore the best way to finance the project. Here we are saying an individual should weigh current expenditures versus future consumption in a framework similar to a company’s capital allocation decision and then decide the best way to fund those current outlays. This means our clients’ current and future consumption should be constrained only by the total value of their assets and not by the ability of those assets to generate income. The choice to fund current spending through debt, sale of assets or receipt of income will rely on analyzing the most efficient use of a client’s portfolio. In theory, the two questions should be considered separately and in sequence. In other words, we should strive to identify the proper balance between our current and future spending needs and then decide the best combination of income, capital appreciation and use of debt to meet those requirements.
When a client states they require more income from their portfolio, what they are really saying is their current cash flows are insufficient to cover their current outflows. The most obvious solution to this problem is to increase current cash flows from stock dividends. Rarely does it occur to clients that the regular disposition of equities can be fundamentally equivalent to increasing the dividend yield of the portfolio.
To illustrate this point, we will use a simple example of why we should be indifferent to receiving dividends or selling equities. Suppose an investor requires $100,000 at the end of each year to fund living expenses. She has a $1 million portfolio invested in 1,000 shares of ETF XYZ, each worth $1,000. If XYZ pays a dividend of $100 per share at year-end, then the income from dividends will meet the spending requirement. However, all else being equal, the value of XYZ will decrease by the amount of distribution. In this case, at the end of the year, the investor will have met her financial obligations and will own 1,000 shares in XYZ worth $900 per share, or $900,000.
Now consider the effect if XYZ does not distribute dividends to shareholders. In this case, the investor would sell 100 shares of XYZ to meet her obligations. At the end of the year, she will own 900 shares worth $1,000 per share. Whether the cash flow requirement is met through dividend income or through the sale of shares leaves the portfolio with the exact same end-of-year value of $900,000.
The above example shows that it should not matter to investors whether stock is sold or dividends are received in order to satisfy their cash flow requirements. This holds only if we keep everything else equal. It should be noted that there is an exception where the preference for income is rational: a trust structure that only allows for the distribution of income to the beneficiaries.
Similar to other investment decisions for U.S. families, taxes will also play a role in meeting these obligations. In the U.S., the top marginal tax rate on dividends and capital appreciation is 23.8%. In our example, the investor who receives dividends and falls in this tax bracket will pay a total of 23.8% of $100,000, or almost $24,000, in federal taxes. However, taxes on the sale of stock apply only to gains (the sale price less the adjusted cost basis). If the cost basis of the stock in XYZ Corporation was $500, the total tax due on the sale would be $23.8% of the $500-per-share gain, or about $12,000. Therefore, our investor in the above example should prefer the sale of stock to dividend income, as long as her cost basis is not zero.
A final fallacy that may induce the preference for dividends over the sale of assets relates to the perceived certainty of dividends when planning for the future. However, global shocks, such as the current pandemic or the 2009 financial crisis, have proved that dividends are not a guarantee. For instance, based on data collected by JP Morgan, over 50% of consumer discretionary stocks in the S&P 500 cut or suspended their dividend in the 12 months ending Sept. 30, 2020 (JP Morgan Guide to the Markets, 4Q2020). During the great financial crisis of 2008 and 2009, dividends on the S&P 500 were cut by more than 20%. Instead of focusing on the perceived safety of dividend income, we encourage our clients to build spending plans with a margin of safety to provide flexibility and optionality in order to meet any unforeseen turmoil, with the comfort of knowing they have planned for the unexpected.
One of the most difficult aspects of providing investment advice to families and institutions is overcoming the preference for income to meet near-term cash flow needs. Teaching clients that a total return focus is superior to an income focus in the vast majority of cases is an important piece of providing an investment solution that will meet a client’s needs over both the short term and the long term. Investors should define their reasonable near-term obligations and long-term goals before deciding how to generate cash flow to meet these obligations.
All else being equal, investors should be indifferent between dividend income and the sale of assets. However, trust structures and tax implications may affect this decision. Finally, a prudent investment plan and the preservation of optionality and flexibility will provide more insurance against market volatility than relying on the (un)predictability of dividend payments.