In the ongoing quest to learn about and add yield a reader left a comment about constructing a portfolio to yield 4% so that nothing would ever need to be sold and that the investor could just live off the dividends (the reader assumes a prudent 4% withdrawal rate).Another reader responded that if reader number one was interested in income and not growth that a muni bond ladder could yield 5%. I do think he does want growth though.
I certainly don't have all the answers but I have opinions and preferences. Constructing a normal equity portfolio to yield 4% is very difficult, even 3.5% would not be easy. When I say normal I mean diversified.
My initial reaction is that in order to get the yield up that high it would require tilting hard to the sectors that yield, at the expense of sectors that don't usually pay much in the way of dividends (like tech which I guarantee will have another day in the sun even if I have no idea when) or it would take loading up on a bunch of leveraged CEFs and at some point too much CEF exposure will bite back hard.
I think the first comment is just framed differently than how I view the issue. In the course of managing a portfolio, dividends come in at some frequency (depending on how you have constructed it) there is also the occasional trade that needs to be placed. If you read that first comment I am responding to you know what I mean as I say it is never so cut and dried and simple as to take in 3% and sell 1%. IMO that just is not how it ever happens.
For someone with the time and inclination maybe they should sell an occasional covered call to enhance yield. If you think about all the people out there selling the idea of 3% a month from call writing maybe that could be toned down to 75 basis points a year? If a portfolio yields 2.75%, which is pretty good, and you occasionally sell a call or two after a big move you could probably add 50 basis points anyway without becoming a junkie who has to have his account constantly re-paired* to determine the option requirements.
*Re-pairing refers to matching up long and short options within an account in such a way as to minimize the amount of cash to secure the position like a credit spread is usually the difference between the strikes and so on. This can be a wildly complex task depending on the number of positions.
The picture is taken from the path down to Hideaways Beach in Princeville on Kauai.
13 comments:
"In the ongoing quest to learn about and add yield a reader left a comment about constructing a portfolio to yield 4% so that nothing would ever need to be sold and that the investor could just live off the dividends (the reader assumes a prudent 4% withdrawal rate)."
I've never understood this desire to increase "yield" so that one can live off the portfolio income and avoid selling anything. I think this is a perfect example of a behavioral finance error.
A 10% return is a 10% return is a 10% return. It is irrelevant whether the 10% return comes entirely from capital gains, or whether you get 4% from "yield" or income and 6% from capital gains.
If one is living off the portfolio, one can easily sell off 4% or whatever value each year to produce the necessary "yield". The idea of creating these mental buckets of "income" versus "capital gains" isn't logical or necessary.
I do think there is a time and a place for high-yielding investments in a portfolio, especially during certain parts of the market cycle. High yielders tend to outperform in a bear market so they are a way to get defensive and still have market exposure. Additionally, one can make the case that often high yield is one factor in selecting an outperforming investment (sometimes a warning sign though).
In any case, I don't see the point in intentionally trying to construct a higher yielding portfolio for the sole purpose of creating "income" to live off of. My own view is portfolios should be managed and constructed for total return.
I document a high yield strategy which I follow on my website.
I'm on the UK where stocks tend to yield more than in the US, however I think the same principles would apply.
A key component of the strategy is that in investing in a portfolio of high yielding shares, the dividends tend to increase every year usually at a rate in excess of inflation.
I'm currently in a capital growth phase whereby I reinvest all income received, when I retire I simply stop revinvesting and take that income.
As I say, if you are interested then look at my site (jargon-free.com) or have a look over at the motly fool uk boards where I got this idea from (board called hyp or High Yield Portfolio)
Roger did not reference my post, but he did reference one that was close (I hadn’t seen the one he referenced). First, though, I make no claim to being right. These are all questions I am thinking about and looking for feedback.
I am considering the possibility of construction a retirement portfolio of pretty much all equities that has a yield of about 3%. I think that would allow exposure to areas like tech that have a much lower yield by including things like Canadian Royalty trusts that yield 16% (at least for now) and ocean shippers with a yield of 10%. I would also keep the IBM’s, Cameco’s, and the Apples with much lower yields. I am looking for an average here, not the highest possible yields. I would also keep two or three years worth of withdrawals (less the expected dividends) in cash so as not be forced to sell in a way down market.
In answer to Mike C’s comment, it would seem this is a safer alternative than looking for the proverbial 10% capital gains in a down or flat market. I think we can all remember 2001/2002 with a way down market and interest rates in the 1% range, but the dividends did keep rolling in. The retirees here in Florida were really hurting with such minimal CD rates. My Dad, as he approached 80, was very concerned about running out of money. In retirement, I need a reasonably predictable minimum return with, as Roger notes, a continuing exposure to the market. I have been a lucky stock picker this year in that I am up 16% including dividends (even after Friday), but that compares to last years total return of 6%. So, I am merely lucky this year, not good. I also do not want to be in the position of one of my friends who relies on a 12-15% return each year to support his lifestyle.
For some reason, I am quite wary of bonds. It is probably mostly emotional, but I really have never done anything with them. I did have a Vanguard 60-40 fund, but it never seemed to do very well. So, I am kind of looking at the high yield portion of the portfolio as a bond replacement with exposure to the market.
I understand Roger’s concern with leveraged CEF’s. Long Term Capital Management comes to mind. Many of those guys trade performance for risk and it doesn’t always work.
I had bad luck with selling covered calls on IBM. The first one worked, so I did it again. But then the stock exploded and I ended up buying them back just to save the stock. The stock was at 94 when I sold the 100 calls, I rolled them once, and then bought them back at a 108 equivalent. I spent a lot of money to make that first $600.
I did look at JFBloggers site too, but didn’t get to Motley Fool, yet
I suspect a lot of this discussion will end up being a religious argument, but I do appreciate any thoughts.
Rick C
Well, if a muni bond ladder yields 5% and he needs 4% could he not do say 80% bond ladder/20% stocks (or mybe 90% ladder/ 10% Cash equivalent/ 10% stocks if he needs liquidity)? After all .05x .8= .04. Assuming he has enough that 4% will sustain him for the foreseeable future there should be some growth there.
Constructing a portfolio with a yield of 4% or whatever so one could live off the yield alone would be the easier part, the harder part would be dealing with what the purchasing power of that 4% (or whatever) looked like 10 or 15 years down the road after inflation got through with it; i.e., barring deflation the odds are high that you could not maintain lifestyle within a fairly short period of time, probably less than a decade (play around with the BLS inflation calculator at http://tinyurl.com/b5nga to see this effect)
IOW, assuming a modest inflation rate of 3%, the portfolio has to gain 7% (3% of which is reinvested) to maintain a real return of 4% past the first year; this assumes break even spending. The same effect could be accomplished if you didn't need all the income and could plough that back into the portfolio of course; not as efficient as when capital gains (price appreciation) is part of the mix, at least at current income tax rates, but workable even if there isn't enough excess income to make the various tax reduction strategies available to higher net worth individuals worth fooling with.
HoosierDaddy,
Am I wrong in assuming that a muni ladder would continue to pay the 4% and not really allow for growth due to inflation? That is kind of my fear of bonds. Then, if interest rates fall again, the ladder may not work any more.
I haven't done the analysis yet, but it seems to me that fixed income will eventually fall behind inflation unless you are only going to use, say 50%, of the income and the reinvest the other 50%.
Someone much smarter than me must have done that kind of analysis.
I do remember my father in law going to all bonds in 2000, but he was over 80 then and the bond income far exceeded his annual spending.
Rick C
Rick C,
Depending upon duration and call features, Muni's could appreciate, but fixed income won't necessarily fall behind inflation with some TIPS and floaters in the mix in any case.
Still bonds are not a "no-risk" investment so I'm not sure what the logic would be in going to an all bond portfolio unless there was excess income coming in and/or the income could be shielded in some way and/or an investor really knew what they were doing.
Which does remind me though that the term 'fixed income' may cause too sharp on focus on the income part and not enough on the virtues of duration. By way of example my father's stories of the Great Depression made a strong impression on me while I was growing up -- paying back a debt in dollars that are _worth more_ than the year before can crush anyone -- so even though we have experienced inflationary times since (ah the joys of a fiat currency) I got into the habit of buying long zero coupon T-bonds when I took out a mortgage (would have been long floaters in the case of a variable rate mortgage) to insure against deflationary loss and, otherwise, regain the original purchase price of the home at maturity. In a similar vein I avoid consumer credit assiduously: Never made sense to me to pay interest on a depreciating asset.
A bit extreme perhaps but habits are what they are. FWIW
Incidentally, as an individual investor, I tend to prefer floaters to TIPS because I have no inflation adjusted liabilities to protect (e/g/, I don't pay COLA to anyone), interest rates tend to react more reliably and more strongly to inflation than CPI, at least in my experience, and I don't have to wait for that reaction while the government goes about calculating an index. But that's an individual choice of course.
Hi RW, you mentioned that in constructing a portfolio the problem was with decrease in purchaing power 10-15 years down the line. I disagree with this as, at least in the UK, companies tend to increase divided payments well ahead of inflation so you should end up with more purchasing power further down the line. Consider HSBC, in 2002 it was paying out 53 cents (yielding 3.8%), in 2006 it paid out 81 cents (yielding 4.2%) that increase is well ahead of inflation.
I'm not saying this is always the case every year, but choosing a diversified portfolio of large cap stocks which have a history of increasing dividends can pay off big time. In difficulty big companies prefer not to cut the difficulty unless absolutly necessary.
Another thing to point out, some of the figures quoted sound very high('ocean shippers with a yield of 10%'). I know nothing of this company but that sounds suspicious to me. It's worth while checking on the companies dividend cover, you want to make sure that it's over 1.5 preferablly over 2. It's not good if a company is paying out more dividend than it earns!
Rick C.
I just sold my Canadian oil trust holdings since that sector has had it's run for a while. And the other Canadian trusts are all I believe in commodities that are priced high. How is not a good time for those risky holdings.
If you check these oil trusts charts you will find that they tank around this time of year and then start to go back up in late December.
Here is a link to Fortune Magazine's "40 Stocks to Retire On."
http://money.cnn.com/galleries/2007/fortune/0706/gallery.fortune40_retire.fortune/index.html
I liked: COP (but not at these prices), UL, PFE, MMM, PBR, ABT, CB, WYE, PG, AIT, LUKK, VFC, PKE, & PVR. That comes out to a little over 2.5% yield. AIB is a favorite of Roger's in banking and it yields 4.4%. NRP is also a good coal trust, but that sector may suffer when the Dem's clean house next year.
That's 15 (not counting NRP) good stocks with yield with some degree of diversification. As someone pointed out, achieving an average yield over 3% in a stock portfolio is quite risky. 2.5% is very good indeed.
roger...and tom k if you're out there...I'm in the camp of tactical allocation...different from Roger whom I have great respect for. In the quest for the infamous exit plans, cash is my first choice, but am considering allocation to an cet,etn, etf that does covered call writing AND writes puts. The former strikes me as still vulnernable to a bear mkt, perhaps best in a sideways mkt. The latter approach, using puts, could hedge against a bear and still provide income. Roger, can you give me a reality test on my reasoning and where to look for writing puts? Seems you've talked a lot about covered call cefs like MCN and FFA...and BWV.
Sorry for some confusion. I meant ocean shippers as a class. Specifically, FRO was yielding 16% when I bought it, ONAV was at 10%, and DSX was about 7%. They have all gone up since, so the yields are lower.
According to Yahoo, FRO did pay out 100%, though, and the other two were even higher. It is hard to see how that can continue.
Rick C
Timing Model = 4.5
100% long
Global allocation of long positions
MSCI EAFE Index 40%
MCCI Emerging Markets Index 30%
Russell 3000 Index - U.S. 30%
Top US Sectors
U.S. Oil & Gas 5.0
U.S. Oil Equipment, Services & Distribution 4.5
U.S. Semiconductor 3.5
U.S. Basic Materials 3.0
U.S. Technology 2.5
Precious Metals 2.5
U.S. Biotechnology 2.0
Top Intl ETFs
S&P Latin America 40 Index Fund 3
MSCI Brazil Index Fund 3
FTSE/Xinhua China 25 Index Fund 3
MSCI South Korea Index Fund 3
MSCI Emerging Markets Index Fund 3
MSCI Germany Index Fund 2
MSCI Mexico Index Fund 2
MSCI Malaysia Index Fund 2
MSCI Singapore Index Fund 2
MSCI Australia Index Fund 2
MSCI Canada Index Fund 2
MSCI Pacific ex-Japan Index Fund 2
MSCI Taiwan Index Fund 2
Maybe I am simplistic, but if he wants a yield of approximately 4%
and inflation protection, just put it all in GE Interest Plus and forget about managing some complex portfolio.
Would I do it? No. But there were a few times that I wish I had.
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