Which is better- Total Return or Income investing?

There was an interesting article on Morningstar by Frank Armstrong where he recommends a total return approach to investing instead of focusing just on dividend income:

“Your grandparents invested for income and crammed their portfolios full of dividend stocks, preferred shares, convertible bonds, and more generic bonds. The mantra was to live off the income and never invade principal. They selected individual securities based on their big, fat, juicy yields. It sounds like a reasonable strategy, but all they got was a portfolio with lower returns and higher risk than necessary.”

Armstrong made several good points and suggested that the goal of modern portfolio theory is to change the focus from individual stock selection to asset allocation and portfolio construction, and to strive for total return, not just dividend yield.

One thing that Armstrong did not discuss was brokerage commissions. If you go back fifty years, brokerage commissions were much higher than they are today. Selling a stock or ETF at a discount broker today may be accomplished for under $10 or less, and many ETFs can be traded now with zero commission. High commissions may have justified our grandparents approach to investing, since it was very expensive to sell off just a small piece of an investment at that time.

Even today, if you use a full service broker who charges $100 a trade or more, it may still make sense to look for high dividend investments even though you earn a lower total return. You certainly can’t afford to trade actively paying $100 a trade or more.

But if you use a discount broker, most of Armstrong’s arguments make a lot of sense. But I would go a step further than Armstrong. Academic research has identified many market timing or active investment strategies that have handily beaten the market before commissions.

For example, graduate student Robert Levy published a classic paper “Relative Strength as a Criterion for Investment Selection” back in 1967 that has continued to work well over the last 43 years. When it was first published, “efficient market” advocates dismissed Levy’s results, and said that commissions and trading costs would wipe out the profit potential of the strategy. That may have been true back in 1967, and may still be true today if you use a full service broker. But it is not true if you use a discount broker, especially if you invest with zero commission, highly liquid ETFs.

In today’s world where you have access to near zero brokerage commissions, more investors should be using an active investment approach. Of course, this would not be in the interest of the large Wall Street full service brokers, mutual fund companies and most traditional financial advisors who still recommend the “buy and hold” philosophy with perhaps a periodic rebalancing. This approach has produced a miserable ten year record in the US, and a horrendous twenty year record in Japan. And the downside risk of a buy and hold strategy is much higher than for many more active strategies.


One response to “Which is better- Total Return or Income investing?

  1. Buy and hold = income investing, and trading = total return? I don’t think that’s quite so.

    One can buy and hold income-orientated mutual funds which can do either approach for you. For example, PIMCO’s PTTRX (Total Return Fund) is an “income fund” with a annualized turnover rate of holdings of 402% (per Moningstar) . PTTRX has a current cash yield of 3.9% and an annualized total return of 10.1% over the past 2 1/2 years.

    PIMCO’s PIMIX (Income Fund) has a turnover rate of 188%, a cash yield of 6.6% and an annualized total return of 9.8% over the same 2 1/2 year period. Both funds have approximately equal average bond durations of ~4.5 years.

    So an investor wanting the higher current yield (paid monthly for both funds), PIMIX would normally be the better fund for a retired investor removing mandated RMDs from an IRA to live on.

    For an investor simply looking to compound total return and not remove income each month, PTTRX would usually be a wiser choice.

    In both cases the funds could be held long term without trading.

    If you want to increase capital by frequent trading, you can do that by yourself or hire someone to do it for you. Normally that would apply to pre-retirement accounts looking to maximize account capital size.

    By the way, this is a great site!

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