Income vs. Total Return: Which Strategy Builds A More Reliable Retirement? (EP.203)

0:28We all need to make smart decisions with our money. that you should only spend the dividends and interest from your portfolio and never touch the principal. When I'm talking to people who prefer to take an income approach, they often classify it as safe and responsible, maybe even intuitive. But here's the truth. This income-only approach isn't nearly as safe or as effective as it seems. In fact, focusing exclusively on income can lead you into hidden risks like chasing yield, sacrificing diversification, and inadvertently increasing the odds of running out of money in retirement. In this episode, we'll expose the biggest misconceptions about income-focused investing and explain why adopting a total return mindset, a strategy that considers both income and capital appreciation, is the smarter, safer, and more flexible approach.

1:22Now, before we dive in, there is a link at the top of the episode description to my cashflow worksheet, because if you're not entirely sure whether your current strategy is sustainable or where your money is even really going, this is just a simple tool to track your spending and make sure that your money is working for you and not slipping through the cracks. But back to income versus total return investing. By the end of this episode, you're going to understand why the income-only strategy feels comfortable but often leads investors astray, how a total return strategy reduces risk and enhances portfolio longevity, finally, practical ways to shift your thinking and implement a total return strategy effectively.

2:06Let's dive in. Total return is simply the combination of two things, income from dividends and interest and capital appreciation or the growth in your investment's value. On the other hand, an income-only investor tries to cover all their expenses solely from dividends and interest, preserving their principal at all costs. Now, this might sound safe not tapping into that principal, but research consistently highlights several pitfalls. For starters, there's an over-concentration in high-dividend sectors. There's also increased volatility and risk during market downturns. Plus, there is way less flexibility and tax inefficiency.

2:48I'm going to link to some of the research in the show notes at thelongterminvestor.com. There's a couple things in there, both from academia and from institutional research, that show that the income-only mindset persists, mostly due to emotional biases. So you have this mental accounting where investors feel safer spending dividends rather than selling principal. There is also a lot of evidence of loss aversion because selling shares feels like losing money despite the economic reality of being the same. And finally, there's anchoring. Perhaps the most powerful for those who are drawn to an income-only approach is that they're familiar with dividend stocks, they're familiar with collecting interest, and this just feels safer due to historical comfort.

3:33Now, let's clearly outline why a total return strategy is better when spending from your portfolio in retirement. Imagine you have a$2 million portfolio and want to withdraw$80 ,000 annually. That's a 4 % withdrawal rate. If your portfolio yields just 2%, that means you only have$40 ,000 in income. So where does the remaining$40 ,000 come from? Income-only investors might chase higher yields, moving into riskier assets like high-yield bonds or dividend-heavy stocks, increasing their portfolio's risk precisely when stability is most needed. Conversely, a total return approach provides more options.

4:16You have flexible withdrawals, so you can draw from both dividends and appreciation, allowing for more strategic decisions. You lower risk by avoiding yield chasing and maintaining broad diversification. And there's improved tax efficiency because you can optimize withdrawals for tax advantages. Another research paper that I'm going to put in the show notes, again, thelongterminvestor.com, comes from the Financial Analyst Journal, and it shows that total return portfolios have consistently shown higher sustainability and better management of market volatility compared to income-only portfolios.

4:51And so if we're going to successfully implement a total return strategy during retirement, that means intentionally structuring your withdrawals and managing your portfolio thoughtfully. So a few actionable steps that just popped to mind for me. The first is obviously determine what your withdrawal needs are clearly. And this is just identifying what your required spending is each year, ideally in dollar terms, to support the lifestyle you desire in retirement. This way, you're not going to anchor your withdrawals to dividends or yield. Instead, you're focusing explicitly on your real world expenses.

5:28The second thing that I think is really important is that you have to strategically rebalance your portfolio. And sometimes this even means that you're going to take taxable gains. In fact, I did an episode exactly on that topic that, again, I will link to in the show notes. Lots of references to the show notes today. And here's the thing. You regularly rebalance your portfolio to generate cash flow. And the approach naturally prompts you to sell investments that have performed well and buy more of those that haven't, keeping your portfolio aligned with your long-term objectives. Now, once you're in retirement, another thing that I like to keep in mind is having an adequate cash buffer.

6:05People have different opinions of how big this should be. I know with clients, we often say one or two years of expenses. Some people feel perfectly fine with just six months, but having this cash buffer reduces the psychological stress of market volatility and helps a lot of people avoid selling assets at depressed values during downturns. Another thing to think about is optimizing your tax situation always, because there are going to be income generating investments that you own, such as bonds, for example. And when you're in retirement, you're typically going to want to hold those in tax deferred accounts while placing investments with more favorable tax treatment, like an index fund or something with minimal income payments or capital gains distributions in a taxable account.

6:50Plus, you can also consider how often will I be able to tax loss harvest to further enhance your tax efficiency. Lastly, I think this is important. It's a little bit of an overarching thought, but you have to think holistically about your portfolio. Generally speaking, I mean, the whole theme here is that we have to avoid treating dividends or interest as the primary driver of your retirement strategy. Instead, view your portfolio as a total return vehicle designed specifically to sustainably support your spending needs, manage risk effectively, and adapt to your changing financial circumstances.

7:25Now, this episode has focused primarily on those living off their portfolio. Adopting a total return strategy, though, is equally essential during the wealth accumulation phase. So if you're still in the saving phase, remember, a total return approach maximizes reinvestment, it harnesses compounding growth a lot better, and it provides for greater long-term financial stability. So to sum it up, while the income-only approach might seem comforting, evidence shows it often creates unnecessary risks and limits your financial flexibility. A total return approach, however, provides superior diversification, flexibility, and long-term portfolio sustainability.

8:10Remember, your portfolio's purpose is to support your goals, not just yield dividends. Thanks for joining me today on The Long-Term Investor. If you enjoyed this episode, subscribe and check out previous episodes. And please leave a review. I read every single one of them. As always, thanks for listening. And until next time, to long-term investing. Thanks for listening to The Long-Term Investor Podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan.

8:57This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.