Yield vs. total return

Chas Craig, BridgeTower Media Newswires

In saving for retirement, many want to build up a principal balance large enough that they can live off the interest and dividends. The admirable desire to leave the principal untouched is a seemingly conservative approach. However, if unchecked, it can lead to retiree portfolios that are much more aggressively allocated than is advisable.

Consider a couple about to retire with a goal to achieve a portfolio yield of 5% in order to provide $50,000 per year of income from their $1 million portfolio. Achieving a 5% yield in a balanced fashion is essentially impossible in the current valuation/interest rate environment and attempting to do so unwittingly exposes these retirees’ principal to considerable risk. Reason being, since 2% is the yield one can now expect to achieve from high credit quality bonds of intermediate maturity, the only way to achieve a 5% yield is to go further out on the risk curve, likely primarily owning high dividend yield stocks.

There are a multitude of portfolios that can be constructed to achieve a yield of 5%. Additionally, it is possible to reach a higher yield than 5%. However, all else equal, ever higher yields are associated with ever higher risk of dividend cuts, and 5% is at the upper limit of what can be achieved within the bounds of prudence.

One dividend-oriented strategy currently yielding a little more than 5% that you may have heard of before is called "Dogs of the Dow." This strategy places equal portions of a portfolio in the 10 highest dividend yield stocks of the Dow Jones Industrial Average and rebalances annually. Of course, there are risks to placing your portfolio in just 10 positions, even if they are taken from a group of some of the world’s most important companies. Having said that, this strategy has successfully delivered its adherents above-average dividend income over the years. Also, although past performance is not always indicative of future results, for the two decades ending 2019, the Dogs Strategy has provided better total returns, to the tune of a little more than 1% per annum (source: dogsofthedow.com), than the overall Dow Jones Industrials Average and the S&P 500.

Probably the most consequential over/under weighting to the overall market for the Dogs Strategy is to the energy sector, where the Dogs Strategy carries a large overweighting (20% versus 3% for the S&P 500) via its holdings of Exxon and Chevron. Although the valuations for these two companies are beaten down and may reward patient investors, the challenges facing the oil and gas industry are well-publicized. Even more importantly, our retirees would have zero exposure to high credit quality bonds.

For the retirees, we would argue it is better to invest their portfolio in a balanced fashion, such as a diversified portfolio split evenly between stocks and bonds, with an emphasis on maximizing total return (i.e. price gains and income) within their risk tolerance. This approach would knowingly accept a modest amount of likely erosion of the original $1 million principal as opposed to accepting an unknowable, but potentially catastrophic risk to principal. Such a severe scenario could come about in the event of a deep and prolonged economic downturn when even many stalwart companies are forced to cut their dividend payouts to preserve their balance sheets. If such a negative outcome came about (we’re not out of the woods on such an occurrence as of this writing), our retirees could find themselves in a position where they have to sell holdings to meet their spending needs, presumably at very beaten-down prices, to offset the lost dividend income.

—————

Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).