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Is "Spend Income, Not Principal" a Good Strategy? Thumbnail

Is "Spend Income, Not Principal" a Good Strategy?

Note: Credit to David Hultstrom, a fellow advisor in Woodstock, GA who originally wrote much of the following, and to many others who have written on this behavioral finance topic. I edited parts of David's work where I thought helpful.  Also, here are some basic definitions to keep in mind:

  • Income or Yield (synonymous terms) = dividends paid by stock or interest paid from bonds or other fixed income assets like CD's.
  • Growth = change in the value of an asset as determined by the market
  • Total return = income from the asset + growth of the asset

I want to address a common investment strategy (“income/yield investing”) and a related spending rule of thumb (“don’t spend your principal”). Despite the superficial attractiveness and a certain forced discipline, neither of these are good strategies. At the end, I’ll offer improved versions of both of those ideas, but here are the four main problems with them:

1) Income doesn’t matter, total return does. Obviously, income contributes to total return (remember, income plus growth equals total return) but what investors should care about is the total return. If the risk were the same, would you rather have an investment that yielded 2% and grew 3% (for a total of 5% return) or one that yielded nothing but grew 6%? Using a non-investment example, when you turn on a faucet to get water, you don't care whether it fell from the sky as snow, sleet or rain. You just want water and the original form doesn't matter. (Though see #4 below for a potential difference in the taxation of difference sources of return.)

2) Focusing on yield frequently leads to increased portfolio risk. There are two ways this can occur:

  • Higher yielding investments all tend to be exposed to the same types of risk (interest rate risk and credit risk) so the portfolio isn’t as diversified as it should be.
  • Higher yielding investments also tend to be riskier investments. The risk of high yield bonds (a.k.a. "junk" bonds) is much higher than investment grade bonds; the risk of real estate investment trusts higher than diversified stocks, etc.

3) Focusing on yield ignores inflation. Inflation is easy to overlook right now but there are two issues:

  • Would you rather have a rental property where you had a tenant on 10-year lease at $1,000/month rent or at $900/month increasing $50/year? That example is obvious, but research has shown that people compare the current yield on stocks and bonds without giving due consideration to the fact that the earnings on stocks are likely to increase over time.
  • Your asset value can effectively go down even while not spending your principal. Inflation in 1980 was running 14% while a 10-year government bond was yielding about 11%. If you spent the 11% yield, the real (inflation adjusted) value of your portfolio declined by 14%. The same is true at lower yield and inflation rate levels, just not as dramatic.

4) In a taxable (i.e. non-retirement) account, yield is often taxed more and/or sooner than growth – even if the tax rates are the same (and income is often taxed at a higher rate). Suppose you have $1,000 and a choice of two investments. One (call it “Y”) has a yield of 10% and no growth and the other (call it “G”) has growth of 10% but no yield. At the end of the first year, you take out $100 to spend. With Y, the entire $100 is taxable. With G, you sell $100 worth and only pay taxes on 1/11th of that (the proportional amount of the gain). In other words, yield (dividends or interest) is a return of the asset value and you get no control over the timing once you decide to own the asset. This is true even if you are automatically reinvesting dividends and it's a particular negative if you really didn't currently need the money.

Now that we’ve seen the four problems with the conventional wisdom, here are the improved versions of our two principles:

First, focus on “total return investing” rather than “income investing” when constructing a portfolio (always considering risk as well, of course). This almost always means some blending of both growth and income type assets.

Second, set your spending in retirement at an appropriate percentage of your portfolio value (often 4% is recommended as a starting point that needs adjustment for many unique factors) rather than spending whatever the income happens to be.

Financial rules of thumb, as well as our own mental accounting tricks (Behavioral Finance), can be helpful or harmful. I've written about these issues here and here, and is why I believe in the value of advice to work through the biases and complexities of our financial lives.

Any information presented here is general in nature, believed to be reliable as of the date published and is not intended to be and should not be taken as legal, tax, investment or individual financial planning advice. Competent, licensed professionals should be consulted when implementing any kind of financial, estate, tax or investment strategy.

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