Total return versus income investing; what's the difference and why is it important to understand?

 

Oftentimes, when discussing investment strategies, especially as they relate to stocks, it is often about whether to take a growth or value-oriented investment approach. In the former you're interested in companies that you believe are growing and will appreciate in price, and in the latter you are interested in companies that may be considered undervalued and can be purchased at price below their true worth. In either scenario, the end game is total return; which is combination of the investment's gain/loss in price + whatever dividends you receive. Thus, a stock purchased for $10/share  that appreciates to $10.75 and pays a $0.25 dividend would provide you with a total return of 10% ($10.75 - 10.00 + 0.25) / $10 or $1.00/$10.

In this low interest rate environment, many investors are drawn to trying to find investments that generate income as their sole or primary investment objective.  As such, investing strictly for income is different than investing for a total return (i.e., appreciation in value + income). Additionally, even though high income producing investments have become all the rage, they can become expensive due to high demand and actually become more volatile and subject to greater price declines when interest rates go up. 

No one's saying income generation shouldn't be a goal for  investors. It is, after all, one of two key components of the total-return equation. The other, obviously, is price appreciation. 

Income producers--whether bonds, dividend-paying stocks, real estate investment trusts or master limited partnerships--can be an important component of investors' portfolios. Also, they grow in importance as a percentage of our portfolios as we age: Focusing on securities with the ability to pay income adds a valuable quality to a portfolio, as income production can be an important indicator of a company's financial wherewithal. From a practical standpoint, income can also provide a cushion on the downside when the market is falling. 

True, the goal for many income investors is to not touch principal but rather to fund expenses with the income that their portfolios generate. In contrast, total-return investors don't reflexively avoid tapping capital for living expenses; retired total-return investors might employ a bucket approach strategy where they have buckets of investments with different objectives (i.e., safety, income, growth, etc.). 

The goal of the total-return strategy is to grow the overall portfolio by maintaining a diversified basket of investments--some income-producing, some that will contribute to the bottom line by appreciating in price, and some that do both. 

The big-picture goals of growing and maintaining a portfolio are the same for both income and total-return investors. 

Combination of the Two

In the end, I think the best answer for most investors is to give due consideration to securities' income-generating potential, but within a total-return framework. 

Blending the two approaches allows investors to benefit from the stability that income-producing securities bring to the table without sacrificing diversification or chasing securities that, in hindsight, turn out to be yield traps. 

A yield trap can occur when an investment appears attractive due to its high yield (i.e., interest rate or dividends paid), but there are other issues not taken into account: 

  • The price of the investment has appreciated due to investor demand and now is overpriced compared to the market. 
  • The company's financial footing is such that it may not be able to continue paying the high yield and subsequently may actually reduce or cut its dividend. 
  • Interest rates tick up and the high yield investment has a much greater decline in value as compared to the overall market. This is due to the fact that these type of investments can be much more interest rate sensitive, which is good if interest rates are declining, but not so good when they on the increase. 

 

Unfortunately, the trap occurs if the investor purchases an investment that is hit by one or several of the above items, which results in the investor feeling trapped. Often, a yield trap appears to be such a good deal that investors subsequently become confused when the investment fails to perform. 

Embedding income producers into a total-return strategy has a couple of other key side benefits. One is tax management: focusing on total return gives investors more control over when they harvest income from their portfolios and where it comes from--a particularly important consideration for investors with substantial assets in their taxable portfolios. A total-return-oriented investor might wisely decide to hold income-producing securities in his/her tax-sheltered accounts, while steering non-dividend payers and/or more growth-oriented investments to the taxable account. 

The bottom line? Resist the urge to classify yourself as either an income or total-return investor. When it comes to the health and stability of your portfolio, the best answer is "both." 

China's dilemma for investors 

China has become an economic powerhouse, and all you have to do is go shopping and find out how many of items you buy are made in China. Hence, many investors think Chinese stocks are the best alternative for growth and profits on the world market. 

Well, China's assumed global economic and stock market dominance may not be as attainable as many pundits claim. Before I go any further, just let me say that the following is my opinion, based upon the numerous articles I've read regarding China and their economy. 

Yes, China has over one billion people, and a growing and manufacturing based economy, but it also has several challenges before it. 

  • First it is a communist country that puts its image before the world at times ahead of what's best for its economy. As a result, China has gone on a construction binge, building massive highways and infrastructure, which in most cases is necessary, but also massive cities of high rise condos, apartments and office buildings. In many cases they're huge areas, similar to downtown KC or say Denver, of vacant or hardly occupied buildings. 

 

Granted most foreigners are in awe of such grandiose projects, but it actually may be a prelude similar to the real estate bubble we experienced in the U.S. in the past decade. 

  • China's regulatory environment is not nearly as developed as compared to United States. Thus, fraud, bribery and poor working conditions and other either unethical or unsavory matters are more commonplace. 
  • Banks often take very liberal approaches in lending money to oftentimes government controlled or affiliated companies. 
  • Leadership at some Chinese companies is either ex-communist officials or closely associated with them. 
  • Consumers now have access to the internet and can see what luxuries are available to them. As such, employees have been demanding higher wages and better working conditions. China's low wage rates have been increasing at an alarming rate, which is causing them to lose their competitive advantage. 
  • China's burgeoning population is of concern to its leaders. When you have over one billion people under communism, then you need jobs to keep them pacified. Embracing capitalism allows you to do so; however, it's a fine balance between not giving them too much freedom or control over their lives. 

 

In addition, China's economic growth at any cost approach has resulted in some of the worst pollution in the world. Also, let's not forget about their only one child policy, which has resulted in an citizenry more heavy slanted toward men. This alone can cause societal issues over time.

Bottom line, China may offer good growth prospects long-term, but based upon all I've read over the past year or so, in the near term, I am becoming less enamored with China as a pure investment play. Thus, Chinese stocks may be a part of an emerging stock mutual fund or ETF, but am I not inclined to buy into a China specific mutual fund or ETF going forward. This is based upon my belief that China is going through some growing pains and will experience some real economic setbacks at some point. For the time being, I believe China's leaders are more interested in presenting an "all is good" image to the world, much like we saw here in the U.S. prior to the real estate and stock market crashes. At some point there will be a market correction and there may be much good buying opportunities. Until then, I am just looking at other options. 

Letting go!

                         

The above is a picture from our recent Colorado vacation. Every two years my wife's family meets in Breckenridge for an entire week. Ironically, 21 people (10 adults and 11 kids) under one roof for seven days is not only survivable, but fun. 

This year we did something different and that I've never done before...riding trails on ATVs. The day started out overcast and cold, and parts of the trails had very large pools of muddy water from all the rain. Even though Jake, my son who was riding with me, and I were wearing helmets and plenty of warm clothes, starting out I was pretty careful to avoid the water as to not get wet. 

This instinct to stay dry is based upon my upbringing and being the oldest child. Basically, I can be too practical at times. In that, does it make sense to get wet and muddy and have to do a load of laundry on vacation? This was my initial thought process. However, as I saw my brother-in-laws and specifically some of my older nephews run through the muddy water screaming at the top of their lungs, I began to rethink my strategy, fight my natural instincts and let go. 

As a result, I did a 180 and began to search for the large puddles (some at least 18 inches deep and quite long and wide). In doing so, Jake and I got soaked, but had an absolute blast! 

In fact, one of my nephews, Justin, was riding behind us and hit a large pool of water and fell face first into the muddy waters. Not only was he not hurt, but I saw the whole event take place and it ended up being the highlight of the day. Seeing him take his helmet off and watching the muddy water cascade out was hilarious and a priceless memory. 

I am extremely thankful for the common sense and extreme practicality my parents modeled during my upbringing. However, this combined with me being the oldest and trying to live by the rules and be responsible has caused me at times to shy away from fully immersing myself in the moment (i.e., spectating versus participating). 

All I can say is that, in life sometimes you have to just let go, have fun and be a kid.  Also, I am sooo thankful for my family for showing me that it's okay to get a little muddy or in my words - color outside the lines. Life can be very stressful, and consequently, I am looking forward to more crazy times with my kids and family! 

Quotes 

"A creative man is motivated by the desire to achieve, not by the desire to beat others."

                   Ayn Rand 

"Try not to become a man of success, but rather try to become a man of value."       

                   Albert Einstein 

"There are no secrets to success. It is the result of preparation, hard work, and learning from failure."

                   Colin Powell

 

Tony Moeller, CPA

 

The information listed in this commentary is a compilation of various publicly available sources and is for informational purposes only. It is not a recommendation or solicitation of any particular investment or strategy. A risk of loss is involved with investments in the stock and bond markets.  

If you enjoy the commentary and believe others may benefit or find it of interest, please feel free to forward it on. Also, interested individuals can contact us, and we will be happy to add them to our mailing list.

Sign up to receive our Commentary

First Name:
Last Name:
Email:
Security Code:
 
Back to top