Total Return Investing
As a financial planner, my primary goal is to help my achieve and maintain financial independence by advising them on sound financial decisions.
To most of my clients, financial independence means achieving a long, happy retirement, filled with dignity and independence - and the ability to leave a legacy to those they care about.
Naturally, assisting them to invest wisely is an important part of this process. And the key to our relationship's long-term success is both mutual respect and a philosophical alignment when it comes to their investment strategy.
In this blog, I argues for my preference for a "total return" investment strategy over a "dividend yield" investment strategy. While this approach my be novel to you, it is supported by rigorous analysis and evidence.
Indeed, yield-focused portfolios will typically lack broad diversification, making them more vulnerable to market meltdowns.
Why do we invest?
The only sane definition of money, in my opinion, is "purchasing power."
Any asset class being considered for your investment portfolio should thus be judged by its ability to protect and grow your purchasing power over time.
We know that inflation, the (mostly) slow but steady rise in prices, is the most significant factor working against us in this goal, because inflation reduces our money's purchasing power.
A well-chosen investment strategy should therefore aim to provide a long-term return that exceeds inflation, enabling you to fund your lifestyle for decades in retirement once you stop working.
What are investment returns made up of?
An investment portfolio should almost certainly include a significant allocation to global stocks - that is, ownership in the world's great companies. This asset class has a long history of outperforming inflation.
Dividends and capital growth are two components of the returns provided by stocks.
Dividends are profits distributed to shareholders by company management after capital has been allocated to growth projects. And wise investors will use these dividends to buy more units in their investment portfolio, which in turn will result in higher dividends in the future.
Capital growth is caused by other investors' willingness to buy shares in the company at increasing prices over time. They do this because the company has most likely demonstrated its ability to grow profits over time, increasing the company's value. As an investor, you benefit from this through an increase in the value of your investment portfolio.
The sum of the dividend return (or yield) and capital growth yields a "total return", and in my opinion that's what you want to pay attention to.
The advantages of focusing on total returns
When advising clients on what investment return is needed to give their financial plan the best chance of achieving its goals, I don't focus to much on the nature of the return (capital growth or dividends).
After all, by taking a total return approach, we know that a portion will come from dividends, and a portion will come from capital growth.
Therefore, neither my clients nor I should really care if returns were generated due to dividends or capital growth. We simply want to maximise the value of your portfolio, building up a retirement nest egg that can give them the income they require when they need it.
This gives us the freedom to focus on structuring a diversified portfolio that is best suited to their needs, because we are agnostic about the elements of return.
And we can therefore avoid becoming over-exposed to industries with a history of paying out higher dividends while being under-exposed to industries with higher future growth prospects. For example, companies in innovative, fast-growing industries tend to reinvest all profits back into the business - leaving no room for dividends. It would be a costly mistake to exclude these companies from our investment strategy.
Let's concentrate on your requirements
This approach to investment management does not imply that we should avoid dividend stocks altogether; rather, I'm simply advocating for not seeking dividends at the expense of the other factors discussed above.
Remember, dividend payments are not guaranteed and are subject to both macroeconomic and company-specific risks.
Another disadvantage of investing in dividend-yield investment strategy is that dividend-paying companies are not typically high-growth companies. There are some exceptions, but high-growth companies rarely pay significant dividends to shareholders, even if they have outperformed the vast majority of stocks over time.
While I understand why some financial advisers favour a dividend-yield strategy, it does not make sense to me. For these reasons I believe that focusing on a portfolio's total return is a better way to manage an investment portfolio.
Amyr Rocha Lima, CFP® is a financial planner who specialises in working with successful professionals age 50+ to help them reduce taxes, invest smarter and retire on their terms.
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