Second Quarter, 2019

At its January 30th meeting, the Federal Reserve Bank decided to “pause” in its journey toward normalized interest rates.  This surprised investors and sent stock prices soaring, a welcome respite from a brutal fourth quarter, 2018. 

Although the pause is good news for investors seeking capital appreciation, it perpetuates a dilemma for those seeking current income, most notably retirees.  In essence, there are three ways they might manage this dilemma.  Specifically, they might … 

Option 1:  Curb their spending. 

While this solution may be reasonable for some, it may unreasonable for others.  For example, a retiree might curb discretionary costs, like travel and entertainment costs, to the detriment of his retirement comfort.  But, he can do little to curb non-discretionary expenses, like food, shelter and health care, without risking his retirement security.

Option 2:  Allocate a greater share of their portfolios to high-income investments.

Historically, a balanced portfolio has provided a gross total return of 8.1% annually including current income of 4.4% annually and 3.7% annually[1][2].  That said; in the aftermath of the 2008 Financial Sector meltdown, the Fed slashed its key interest rate to “zero”, holding it there

for a full seven (frustrating) years in an attempt to “jump-start” the economy.  As a consequence, the current income from balanced portfolios fell by almost 40% and investors began “stretching” for yield[3].  To increase current income, they began buying …

  • Longer term bonds.

They sold short-term bonds and bought intermediate-term bonds, and sold intermediate-term bonds and bought long-term bonds.  As investors did this, current income rose but remained below the historical average. 

  • Lower quality bonds. 

They sold high-quality bonds and bought low quality bonds, like high-yield (“junk”) and emerging markets bonds.  Again, current income rose but remained below the historical average. 

  • High-income stocks. 

They sold low-income stocks and bought high-income ones, like preferred stocks, real estate investment trusts (REITs), and electric and telecommunications utilities. Yet again, current income rose but remained below the historical average. 

Inexperienced (and unsuspecting) investors greatly increased their portfolios’ risk profiles by making these stretches.  By contrast, professionals know such stretches raise “interest rate” and other risks.  They know when interest rates rise, long-term bonds fall more than intermediate-term bonds, which, in turn, fall more than short-term bonds.  They know low-quality bonds fall more than high-quality stocks.  And, they know high-income stocks fall more than those of the broad market where prices might be supported by higher earnings and dividend growth rates. 

Professionals carefully evaluate “compensated” and “uncompensated” risk when they are making investment decisions.  Consider this real-life scenario …

The 90-day T-bill is yielding 2.40%, representing your “risk-free” return.  You could buy it or you could buy the 10-year T-bond yielding 2.41% (+1 basis point) or 30-year Treasury yielding 2.81% (+41 basis points).  Would you be reasonably compensated if you bought the 10- or 30-year T-bond? 

In our opinion, no because you take more time and market risk to gain only a minimal increase in return.  For example, if interest rates rise by 1%, a 10-year T-bond will fall by about 10% in value vs. a potential gain of 1/100th of 1%.  Whereas, the 30-year T-bond will fall significantly more for a potential gain of only 41/100th of 1%.    And, barring a recession, we believe the Fed will resume its journey toward normalized interest rates in early-mid 2020.  Although there are clouds on the global economic horizon, the domestic economy remains strong with full employment, and rising wages and benefits. 

Option 3:  Invest for total return. 

While curbing your spending may be unpleasant, investing for higher-income may be truly hazardous to your wealth.  For this reason, we advocate investing for total return.

Total Return =

Current Income +

Capital Gain

This strategy is well-supported by modern portfolio theory, a large body of research regarding sustainable withdrawal rates and how to achieve them, and the Uniform Prudent Investor Act. Here’s how it works. 

As with the high-income strategy, current income from dividends and interest is a key source of “cash flow” but it is not the only source.  Rather, when it is insufficient, capital is distributed to fill the spending gap.  This strategy offers important advantages over a high-income strategy.  Specifically, it …

  • Allows for proper diversification across and within industry sectors.  By contrast, high-income portfolios concentrate investments in a few industry sectors, like REITs and utilities.  Whereas diversification lessens portfolio risk, concentrations increase it. 
  • Offers a greater probability of long-term success.  For example, the “Trinity” study found that a portfolio composed of 50% common stock had a 100% probability of sustaining 4% withdrawals (adjusting them annually for inflation) for 25 years and 95% probability of sustaining them for 30[4].  By contrast, a portfolio composed of 25% common stock had only a 96% probability of sustaining them for 25 years and 74% probability of sustaining them for 30[5].  From a planning perspective, most individuals should assume they will spend at least 30 years in retirement. 

Moving toward mid-year, we anticipate that the Fed will continue its pause in raising interest rates.  And, we anticipate that the economy and the stock markets will respond positively.


[1] Our firm defines a balanced portfolio as 50-60% common stock and 40-50% bonds.

[2] 2018 SBBI® Yearbook Stocks, Bonds, Bills, and Inflation®: U.S. Capital Markets Performance by Asset Class 1926-2017, Duff & Phelps, Chicago, IL (2018).

[3] Ibid.

[4] Cooley, Philip L., Hubbard, Carl M. and Walz, Daniel T. Sustainable Withdrawal Rates From Your Retirement Portfolio (Table 2), Association for Financial Counseling and Planning Education (1999).

[5] Ibid.


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