How should you invest for retirement?
Should you use a fixed income strategy or seek a total return strategy?
Times change and how we invest has changed over the years as new scientific study better explains how the stock market works and more encompassing ways to invest across the markets. The traditional approach was to create an income portfolio (more about that later) by chasing dividends, bond yield and interest, with a reluctance to touch “principal.” A lot of potential income was actually lost that way and people took more risk than was necessary.
Traditional Investment Approach: Chasing returns, chasing bond yield, throwing money at the stock market and hoping for a livable result.
Scientific Investment Approach: Developing a total return strategy aimed to produce the desired income needed to fund your goals.
Traditional Investment Approach: Don’t touch my principal!
Scientific Investment Approach: Capturing the gains is better than riding the winners back down. Over time, we look to the stock market to generate returns that outpace inflation so a total return strategy is more likely to help you meet your goals.
Traditional Investment Approach: I’m going to retire soon (or am retired now), so I should move my portfolio over to bonds and CDs to get a reliable fixed income.
Scientific Investment Approach: The key is to maintain your purchasing power, not your original investment. Inflation is the culprit; owning the right balance of equities for growth, according to your Risk Tolerance, better positions the portfolio to protect your purchasing power.
But, bonds aren’t risky or dangerous, right?
Actually, that’s not quite accurate. Here is how risk plays out in bonds:
- Interest rate risk: when market rates go up, the value of current bonds typically goes down; which lowers bond yield as well
- Bond gets called early: When market rates go down, bonds may get called because the issuer can get cheaper money by replacing their bonds.
- No buyers: in every trade, there are two sides, a buyer and a seller. If it is low quality junk or rates have moved a lot, it’s harder to find a buyer.
“Fixed income” assets don’t grow and are subject to declining values. If creating an income stream is your goal, then it should not matter how the income is derived so long as the portfolio maintains its purchasing power. When viewed this way, stocks, bonds, CDs, US treasuries, and even money market funds can be viewed as sources of income; a portfolio manager can sell these securities and rebalance the portfolio to create the necessary income. As a side benefit, structuring a portfolio for total return may also cut income taxes. At current income tax rates, and depending upon tax bracket, paying a long-term capital gains tax rate may be preferable to paying taxes on interest income from bond yields.
This is the idea behind a total return strategy.
So, what, exactly, is a total return strategy?
Well, in its basic form it can be expressed as: Total Return = Income (dividends/interest) + Capital Gains
Investors can use this scientific approach to invest in a way to protect themselves and their portfolio’s purchasing power. Letting go of some of those traditional ways that focused on chasing dividends, interest, and “fixed income” can give way to a portfolio with a total return strategy.
How long does this total return strategy need to last?
That depends on the investor and is highly variable. Want to make your financial plan foolproof? Figure out your drop dead date. Literally. Otherwise, you can consider your family history, the state of your health, your lifestyle and maybe even head over to the social security website to check your life expectancy figures. In truth, unless you have a chronic life-threatening illness, you should probably plan for the last person remaining in your relationship to live at least into their mid 90s. For those of you retiring in your 60s, that means you may need to generate a total return for 30 +/- years!
How do you do you create a total return strategy?
An appropriate total return portfolio will take into account your need for income and combine it with the need for long-term growth over the period during which you are not earning a regular salary. A well-diversified portfolio with assets in stocks and bonds may be able to generate more total income than one that is concentrated only on “fixed income.”
By structuring a portfolio in this way, investors can stop chasing individual bond yield and stock dividends by investing in mutual funds that offer what both the stock market and the bond market, have to offer with a Total Return Strategy.