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Wealth Watch / Yield today or lifestyle tomorrow

Published 10:19 am, Wednesday, July 16, 2014
  • Lex Zarahoff Photo: Contributed Photo, Contributed / New Canaan News Contributed
    Lex Zarahoff Photo: Contributed Photo, Contributed

 

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One often hears, "I am conservative. I only withdraw income and never touch principal."

It may surprise you that this approach is not the best strategy to achieve most financial goals and leads to one of two undesirable consequences: 1) You set a spending target that is lower than you can afford, thereby depriving yourself of certain comforts and pleasures that you deserve; or 2) you end up with less purchasing power in later years, thus reducing your flexibility for spending, gifting to heirs or supporting favorite charities.

These unfavorable outcomes occur because a yield-oriented strategy fails to create a properly diversified, tax-efficient portfolio that will have the highest likelihood of meeting your cash flow needs over time. Here's why:

An income focus can lead to a riskier portfolio. Optimal portfolios are well-diversified across various sources of returns and risks. A portfolio focused primarily on one component (like income) will fail to optimize the risk and return. With an income-generating focus, you might overweight your portfolio with high-yield (i.e., low quality) bonds and high dividend stocks in aging industries, while overlooking sectors with higher return prospects, such as technology and emerging markets. History reveals many examples of assets promoted as providing high income that proved to be very risky: low-quality "junk" bonds, high-yield closed-end funds, sub-prime mortgage securities, auction-rate preferred stocks.

Withdrawing interest will not preserve purchasing power. Some refer to U.S. Treasuries as "risk free." Though you may be certain to receive your principal back, treasuries carry considerable inflation risk. For example, if you purchase a 20-year U.S. Treasury bond today and live off the interest payments, the principal you receive back will have lost purchasing power.

High-yielding investments may not be great long-term investments. Bonds may have high interest payments, but they offer no opportunity for growth in their value on redemption. Stocks that pay high dividends may do so because the company has few interesting investment opportunities and little growth. Attractive dividend levels today may not be sustained over time if the company's prospects dim.

Focusing on income may lead to paying unnecessary taxes. The tax rate for interest income is substantially higher than the rate on capital gains. Stocks that generate capital gains can provide far more efficient cash flow than income from bonds.

A "total return" approach to investing is often a better method. In this approach, principles such as asset allocation and diversification are applied to design a portfolio that properly balances risks and expected returns from a broad array of asset classes to match your lifetime financial goals. After-tax cash flows from interest, dividends, capital gains and sales of securities can be applied to meet current cash needs, while any excess can be reinvested for future portfolio growth.

In developing your investment approach, it is important to first define your goals, then develop a plan that balances these goals with risks. A "total return" approach to portfolio design will improve the likelihood that the portfolio will support your goals.

Lex Zaharoff, CFA, is a senior wealth adviser with HTG Investment Advisors, an independent fee-only advisory firm in New Canaan, and an adjunct professor at New York University's Stern School of Business. For information, call 203-972-8262 or visit www.htginvestmentadvisors.com.