For self-funded retirees, the most common question we hear is how to transition from “growing wealth to living off it”. Of course, this is a really sensible query but unfortunately for most ‘do it yourself’ or DIY investors, a number of the important aspects of modern portfolio construction get confused.
Dividends are not "the source of the nile”
Over the last few decades, many Australian investors have been enticed into a false sense of security relying too heavily on high dividend or ‘yield stocks’ as their primary source of regular income. We can’t blame them however, Australian equities have one of the highest dividend payout ratios in the world.
Let’s remember though, Australia isn’t the only country in the world with self-funded retirees who also invest in equities. So how do our peers overseas retire and transition to income focused portfolios?
Thank goodness life isn’t a box of chocolates
Chocolate is easy to eat and gives us that instant sense of ‘satisfaction’, but this doesn’t necessarily mean we should just eat Cadbury’s. Investing is the same and to stay financially healthy we need a balanced approach which takes place at the asset allocation level, not at the ‘dividend’ level.
Herein lies the risk investors don’t always consider: oversized dividends are only great for short periods of time but just like a sugar rush, we can’t rely on them for everything.
Why there is confusion between dividends and ‘income’
Many ‘DIY’ investors confuse the characteristics between asset classes with one another.
- Fixed Income is the traditional ‘go to’ for income investors because of its capital stability and regular interest payment characteristics. We classify this asset class typically as a ‘defensive asset’.
- Equities, which represent ownership in an enterprise that is seeking to grow its profitability (likely in a highly competitive market) and is the traditional ‘go to’ for investors seeking long term capital gains. We classify equities as a ‘growth asset’ which typically comes with more risk than fixed income.
That all makes sense but why are self-funded retirees falling into the trap of owning excessive amounts of equities which are a growth asset that comes with volatility and less capital stability than fixed income?
Squeezing water from a stone
It is well known that fixed income or bond yields have fallen dramatically over the last 30 years. This has forced many income investors to seek cash flow from other sources. Many self-funded retirees have sought their retirement income from residential property and/or equities.
The problem simply put: both property and shares are growth assets. They are not fixed income securities and they come with ‘operational risk’. On top of that, like any good fund manager, CEO or professional investor knows – if the investment pays out all of its profits, the asset is putting itself at serious risk.
What is sustainable and what is not
With equities, if you pay out most or all of your profits you are likely to be left with little or no firepower to reinvest or fend off inevitable competition, secular change or technological disruption. This makes any company vulnerable to aggressive competitors who themselves are investing to capture your market share.
Over time, high dividend payments will be the greatest threat to the company and by default put the investor’s dividend at risk. We call this a ‘dividend trap’.
“But I’m a retiree, how am I supposed to live?”
Professional investors know for better long term results it is safer to focus on a ‘balanced diet’ of companies that not only are less volatile long term but significantly less sensitive to share price ‘hits’ during economic contractions.
It is well documented that companies that practice better capital management outperform over the long term companies that are over leveraged or have excessive dividend payout policies. Some great companies (like Berkshire Hathaway) choose not to even pay a dividend yet are still considered great ‘income’ stocks and are widely owned by self-funded retirees.
“What?!”you might say. “How can a company be an income stock and not pay a dividend?”
Income stocks should not be defined by their dividends
Let us revisit that stocks are not bonds and bonds are not stocks.
Bonds pay interest on a set liability and Stocks pay dividends after they have made a profit. If there’s no profit, there’s no dividend!
By focusing on the quality of the profit, often measured by the free cash flow yield, we get a strong feel for how ‘safe the company is’. Whether they decide to reinvest, pay down debt or pay a dividend really doesn’t matter –we know that we have a great investment.
Income investors should be chasing the growth of free cash flow yields, , not dividends.
What if my yield stock doesn’t pay a dividend?
Outside of Australia, most ‘yield stocks’ don’t actually pay high dividends either. This is not because non-Australian companies are greedy but because dividends are often taxed at higher rates than capital gains in other economies. So it’s the tax regime that drives dividend payout ratios.
So how do self-funded retirees everywhere else in the world do it? If they don’t have a professional adviser working for them (or are just invested in an industry managed fund), then DIY’s simply have to be a little more active with ‘harvesting their income streams’. They know the long term net capital benefits are worth it – materially.
Portfolios should never be put on autopilot
DIYs recognise that stocks rarely trade at their ‘fair value’ and are often overbought or oversold at any given time. The savvy investor knows this and simply takes modest profits or ‘harvests income’ when a stock is overvalued, cashing in on both the company’s success and the ‘free money’ the market providing the investor through a momentary overvaluation.
However for many, this simply might be too much work. In that case, a regular periodic asset allocation rebalance regiment is all you need to do and what the majority of DIY’s and professional investors implement.
Professional investors generate income streams through rebalancing not chasing dividends
Like moderate exercise, rebalancing your portfolio on an annual or semi-annual basis is very healthy. Many studies have shown that not only does rebalancing allow you to free up precious invested capital for ‘lifestyle’ cash withdrawals but will overtime improve the overall performance and reduce volatility within the portfolio itself.
It can be tempting to put your portfolio on autopilot, especially when you have quality blue chip names.
However if autopilot investing was that easy – then everyone would do it!