July 19, 2021

Investment Committee

We all want income – but cash is what we really need?

Some of us still yearn for a simpler time, when we could expect to retire and live comfortably on interest and dividend income from our investments.  Protecting the principal of our nest egg would allow us to live many happy years without fear of running out of money.  Of course we may still want to take some stock market risk, in the hope that rising stock prices would increase our principal value enough to offset the impact of inflation.  Ideally, the growth in principal value would allow our income to grow enough to maintain its purchasing power.

If only it could be that simple.  In the 1950’s dividend yields exceeded 5% and in the 1970’s and 1980’s dividend yields averaged more than 4% on the S&P 500.  By March 2000 dividend yields had dropped below 2%, but the ten-year Treasury was yielding 6.2%, so a diversified portfolio could still generate income.  Times have changed.  Today, the dividend yield on the S&P 500 is 1.4%, and the yield on ten-year Treasury bonds is hovering around 1.5%, while inflation expectations are 2%, and maybe a good bit higher in the short term.  A diversified portfolio will not provide much income, and a bond portfolio will not maintain its purchasing power, even if all the interest is reinvested.

Is Spending Principal Bad?

Not necessarily, but it can be.  Take the example of municipal bonds, which are often issued with large coupons, so today you can purchase a ten-year tax exempt bond with a 4% coupon, or interest payment.  It sounds good, but there is a catch.  You have to pay $122 today for every $100 of face value, which will be the amount of principal returned to you ten years from now.  Over the ten year period you will receive 4% of face value, but that really represents interest income (yield if held to maturity) of 1.47% while the rest is an early return of your principal.   If you spend the 4%, you are spending part of your principal, and will have only $100 to reinvest (rather than $122) when the bond matures.

Total Return Can Provide Cash Flow And Protect Purchasing Power

The total return on stocks (dividends plus price appreciation) is more important than ever in a diversified portfolio that needs to provide current cash flow and protect purchasing power for the long term.

Stocks tend to appreciate in value, so selling a few shares of stock can be the best way to meet cash flow requirements.  Of course stock prices go up AND down, so selling stock can feel like you are spending down your principal, and no one wants to do that.  The fear of spending principal should be put in perspective.  The average annualized return on the S&P 500 from 1950 to 2020 was 11.2%, which includes 3.3% from dividends and 7.9% from price appreciation.  The 7.9% was not income, and could only be spent by selling shares.

Some Things Are Different And Some Things Are Not

With low interest rates, and low inflation expectations, we should expect a lower total return from stocks than what we observed on average from 1950 to 2020, and of course no one can predict stock movements in the short run.  However, we expect the total return on stocks to be meaningfully better than cash or bonds, so understanding how to use the total return to fund retirement spending will continue to be important for a comfortable retirement.

Managing portfolio risk, monitoring asset allocation, rebalancing, and managing cash flow are all part of what we do at Rockbridge.  Let us know if you would like to discuss how your investment portfolio will fund your future cash flow needs.

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