One of the persistent questions lately is how long the low-yield environment might last. Rates should be seen as a symptom of the sluggish economic growth that has come in the aftermath of the global financial crisis.
A financial crisis is often followed by a slow economic recovery and is often associated with low rates as the monetary authorities seek both to stabilize the financial system and to promote economic growth. That said, it’s anyone’s guess about the exact timing of when rates will begin to rise. So investors, as usual, need to build a portfolio to address a number of scenarios, including stable or higher rates over an uncertain time horizon.
This question about low rates highlights a growing divide with how many investors approach the problem of generating portfolio income. Many investors take an “income investing” approach, living off income yields from stocks, bonds, and other assets. In order to increase income, they switch to higher-yielding (and higher-risk) investments—for example, by moving to long-term corporate or high-yield bonds.
By comparison, many financial planners take a “total return” approach to income. In this approach, the investor sets an overall portfolio allocation of stocks, bonds, and other assets based on long-term risk tolerance. And then the investor spends in a disciplined way from the portfolio according to some spending rule. The amount spent from the portfolio can consist of income, capital gains, or principal over time.
As an illustration, a traditional retired income investor with $100,000 to invest today might be able to squeeze $3,000 worth of income (after expenses) from a diversified portfolio of higher-risk bonds and higher-yielding stocks. By comparison, the same investor with a total-return approach would invest that $100,000 in a broadly diversified portfolio of stocks, bonds, and other assets (not tilted toward higher yields) and then draw down, say, 4% of portfolio assets. (If the $100,000 were in a taxable account generating taxable income of 2% or $2,000, the investor would first spend that $2,000 and then withdraw another $2,000 of principal. If the money were in an IRA, the investor would redeem 4% of the total value.)
Many traditional investors object to this model, saying that it’s too risky to be drawing down principal when stock prices are volatile. But they tend to overlook the risks associated with traditional income investing. When you tilt your portfolio to high-income bonds, you ramp up your exposure to interest rate risk. When you tilt your stock portfolio to high-yielding equities, you typically also tilt it away from future growth. This is particularly true if the high-yielding asset class (think, for example, about the recent run-up in dividend-paying stocks) has become fashionable and is quite expensive.