Beyond Dividends: Why Total Return Investing Trumps Income-Only Strategies

Oct 30, 2024 | 5 min read

Picture this: You're scrolling through social media and see a post about a stock paying massive dividends. It's tempting, right? The idea of your investments paying you regularly sounds like a dream. But here's a plot twist that seasoned investors and financial advisors know: chasing high dividends might actually be holding back your long-term financial growth. Let's unpack why a total return approach to investing often outperforms an income-only strategy.

Understanding Total Return vs. Income Investing

Before we get into the details, let's define our terms:

• Income Investing: This strategy focuses on investments that provide regular cash flows, such as dividend-paying stocks or bonds.

• Total Return Investing: This approach considers both the income generated by investments and their potential for capital appreciation.

The Pitfalls of Income-Only Strategies

While income investing might seem attractive, especially for retirees or those seeking regular cash flow, it comes with several potential drawbacks. Let's look at some common income-focused strategies and their impacts:

1. Overweighting Longer-Term Bonds Impact: Increases exposure to changes in interest rates. Many income investors are drawn to longer-term bonds because they typically offer higher yields. However, these bonds are more sensitive to interest rate changes. If rates rise, the value of these bonds can drop significantly, potentially offsetting or exceeding the benefit of the higher yield.

2. Overweighting High-Yield Bonds and/or Underweighting U.S. Treasury Bonds Impact: Increases credit risk and raises overall volatility. High-yield bonds (often called "junk bonds") offer attractive yields, but they come with higher default risk. By overweighting these at the expense of more stable U.S. Treasury bonds, you're increasing your portfolio's overall risk and volatility.

3. Increasing Exposure to Dividend-Centric Equity Impact: Decreases diversification of equity portfolio by overweighting certain sectors and/or increases overall volatility and risk of loss if it reduces the bond portfolio. Dividend-paying stocks are often concentrated in certain sectors like utilities, consumer staples, and financials. Overweighting these can reduce your portfolio's diversification. Moreover, if you're reducing your bond allocation to buy more dividend stocks, you're likely increasing your portfolio's overall volatility.

The Benefits of a Total Return Approach

Now that we've seen the potential pitfalls of income-only investing, let's explore why a total return approach often makes more sense:

1. Better Diversification A total return approach allows for broader diversification across different asset classes, sectors, and geographies. This can help reduce overall portfolio risk.

2. Tax Efficiency Dividend income is often taxed at higher rates than long-term capital gains. By focusing on total return, you can potentially reduce your tax burden by controlling when you realize gains.

3. Flexibility With a total return approach, you're not limited to only high-yielding investments. This allows you to invest in growth-oriented companies or sectors that may offer better long-term returns.

4. Inflation Protection Dividend payments don't automatically increase with inflation. Growth stocks, which might not pay dividends, can provide better inflation protection as their earnings (and potentially stock prices) rise with inflation.

5. Avoiding Yield Traps High dividend yields can sometimes signal a company in distress. A total return approach helps you avoid the temptation of these "yield traps."

Implementing a Total Return Strategy

So, how can you implement a total return strategy in your portfolio?

1. Focus on Overall Returns Instead of fixating on dividend yield, look at a fund or stock's total return over time.

2. Use Broad-Market Index Funds These provide exposure to both dividend-paying and non-dividend-paying stocks.

3. Consider Growth Stocks Don't shy away from quality companies that reinvest profits instead of paying dividends.

4. Rebalance Regularly This helps maintain your target asset allocation and can be a source of "homemade dividends" through selling appreciated assets.

5. Use Tax-Efficient Withdrawal Strategies In retirement, you can create your own "income" by strategically selling assets, potentially in a more tax-efficient manner than relying solely on dividends.

Case Study: The Power of Total Return

Let's look at a hypothetical example to illustrate the potential difference between income and total return investing:

• Investor A (Income Focus): Invests $100,000 in a high-dividend stock fund yielding 4% annually. After 20 years, assuming no change in share price and reinvestment of dividends, they'd have about $219,000.

• Investor B (Total Return): Invests $100,000 in a broad-market index fund. Assuming a conservative 7% annual total return (including both price appreciation and dividends), after 20 years, they'd have about $387,000.

This simplified example ignores taxes and many other factors, but it illustrates how a total return approach can potentially lead to significantly more wealth over time.

The Role of a Financial Advisor

Implementing a total return strategy effectively can be complex. A financial advisor can help by:

1. Designing a Diversified Portfolio They can help create a mix of investments aligned with your goals and risk tolerance.

2. Managing Withdrawals In retirement, they can help implement tax-efficient withdrawal strategies to create the income you need.

3. Behavioral Coaching They can help you stick to your strategy during market volatility, when the temptation to switch to "safer" income investments might be strong.

4. Tax Planning They can help minimize the tax impact of your investment strategy.

Final Thoughts

While the allure of regular investment income is understandable, a total return approach often provides a better path to long-term financial success. It offers greater flexibility, potentially higher returns, and better risk management through diversification.

As a young investor, you have a powerful advantage: time. By adopting a total return approach now, you're setting yourself up for potentially greater wealth accumulation over your investment lifetime. Remember, it's not just about the income your portfolio generates today, but the total value it can provide for your financial future.

For a more comprehensive look at how financial advisors can add value through asset location and other strategies, check out our in-depth blog post: The Hidden Value of Financial Advisors: More Than Just Investment Returns.

Whether you're just starting your investment journey or considering a shift in strategy, consider the benefits of a total return approach. It might not provide the regular "paycheck" that income investing seems to offer, but it could provide a bigger balance in your account when you need it most.

At Israilov Financial, we specialize in creating personalized, total return-focused investment strategies. If you're interested in learning how we can optimize your investment approach for long-term growth, schedule your free discovery meeting.

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IMPORTANT DISCLAIMERS

Past performance is no guarantee of future returns

The graphs and charts in this commentary are for illustrative purposes only and not indicative of any actual investment. Index returns do not reflect any fees, expenses, or sales charges. It is not possible to invest directly in an index. Stocks are not guaranteed and have been more volatile than other asset classes. Historical returns were the result of certain market factors and events which may not be repeated in the future. Financial professionals are responsible for evaluating investment risks independently and for exercising independent judgement in determining whether investments are appropriate for clients.

This material is intended for information purposes only, and does not constitute investment advice, a recommendation or an offer or solicitation to purchase or sell any securities.

Disclaimer: Investments are not guaranteed and are subject to investment risk, including possible loss of the principal amount invested. Past performance is no guarantee of future results. All allocations and opinions expressed are as of the date of this presentation and subject to change. The information contained herein does not constitute investment advice or a solicitation. Information obtained from 3rd parties is believed to be accurate, but has not been independently verified.

The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Israilov Financial LLC cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Israilov Financial LLC does not provide tax or legal advice, and nothing contained in these materials should be taken as such.

As always, please remember investing involves risk and possible loss of principal capital. Advisory services are only offered to clients or prospective clients where Israilov Financial LLC and its representatives are properly licensed or exempt from licensure. No advice may be rendered by Israilov Financial LLC unless a client service agreement is in place.