Hidden Risks of High-Income Strategies
Beyond Dividends: The Hidden Risks of High-Income Strategies
Income is a critical component of an investment strategy. After all, the value of any asset depends on its ability to provide a return on capital. However, some investors place too much emphasis on generating income in their portfolio, searching for high dividend-paying strategies to earn a greater rate of return.
Often, someone expresses that they'd "like to live off the dividends and not touch the principle." This convenient accounting distinction between principal and income can be reassuring for someone concerned about running out of money or desires to leave a portion of wealth to one's heirs. It's also common to structure a trust so that a beneficiary receives the income, leaving the principal to a future benefactor. Focusing on earning an above-average income can often lead to some critical pitfalls.
The Challenges of an Income Strategy
Take the Global X SuperDividend ETF as a proxy for a high dividend-paying strategy. It comprises 50 of the highest dividend-paying stocks in the US and currently has a dividend yield of about 7%. Yet over the last decade, ending November 2023, it delivered an annual average total return of 2.2%, which indicates the fund experienced capital losses that offset most of the dividend income.
We believe an investor considering an income-paying strategy should be aware of some drawbacks associated with this high-income strategy:
Limited Growth Potential: Dividend-paying stocks may not experience the same level of capital appreciation as other stocks. Companies that distribute a significant portion of their profits as dividends may have fewer funds available for reinvestment in the business, potentially limiting their growth prospects.
Interest Rate Sensitivity: Dividend stocks can be sensitive to changes in interest rates. Dividend-paying stocks have some attributes of bond investments and may decline in value if interest rates suddenly rise.
Vulnerability in Economic Downturns: Dividend-paying companies may face challenges during economic downturns. If a company's earnings decline, it might struggle to maintain or increase its dividend payments. This can lead to a reduction in income for investors relying on dividends.
Dividend Cuts: Companies may cut or suspend dividend payments in difficult financial situations. Often, high dividend yields reflect the market's expectation that a company will reduce future dividends.
Tax Implications: Dividend income is generally taxable, which can reduce the after-tax return for investors. The tax treatment of dividends can vary depending on factors such as the investor's tax bracket and the holding period of the investment.
Sector Concentration Risk: Investors concentrating on dividend-paying stocks, especially within a specific sector, may face increased risk if that sector performs poorly.
Yield Traps: High dividend yields sometimes signal financial distress or an unsustainable payout. Investors should be cautious of "yield traps" where the company's fundamentals do not support a high yield.
Investors should carefully assess their financial goals, risk tolerance, and time horizon before adopting a dividend-focused investment strategy. Diversifying across different asset classes and investment styles can also mitigate some drawbacks of any single strategy.
Total Return - a Better Approach
In many cases, a total return approach may better serve investors. The total return approach to investing and spending incorporates the prospect for capital appreciation and income generated from an investment. This provides a more comprehensive measure of an investment's performance than looking solely at income. Here are some benefits of adopting a total return approach:
Flexibility in Spending: By considering capital appreciation and income, investors have more flexibility in determining how much they can withdraw or spend from their investment portfolio. This flexibility can be especially valuable in retirement when individuals may need to balance their income needs with preserving the capital for the long term.
Adaptability to Market Conditions: Market conditions can vary, and a total return approach allows investors to adapt to changing economic environments. For example, investors may rely more on capital appreciation in periods of low-interest rates. In contrast, income may play a more significant role in high-interest rate environments.
Diversification Opportunities: The total return approach is not beholden to companies with high payouts or lower earnings growth and is broadly diversified across asset classes and economic sectors. By holding a mix of investments, including stocks, bonds, and other asset classes, investors can benefit from different sources of return and reduce exposure to specific risks.
Tax Efficiency: Focusing on total return may allow for greater tax efficiency. For example, strategically realizing capital gains, such as during years with lower income, can result in more favorable tax treatment than relying solely on ordinary income.
Pay Yourself a Synthetic Dividend
Investors seek a sustainable withdrawal strategy that aligns with their ideal retirement or legacy plans. Through careful planning and portfolio construction, we encourage investors to create a sustainable synthetic dividend from their portfolio. A total return approach to designing and implementing an appropriate investment strategy provides better outcomes, aligning investment strategy with life goals.
Contact us at 865-584-1850 or info@proffittgoodson.com
DISCLOSURES: The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy, or investment product, and should not be construed as investment, legal, or tax advice. Proffitt & Goodson, Inc. makes no warranties with regard to the information or results obtained by third parties and its use and disclaims any liability arising out of, or reliance on the information. The information is subject to change and, although based on information that Proffitt & Goodson, Inc. considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data suppliers (Interactive Data Corporation, Morningstar, etc.). The Market Categories illustrated in this Financial Market Summary are indexes of specific equity, fixed income, or other categories. An index reflects the underlying securities in a particular selection of securities picked due to a particular type of investment. These indexes account for the reinvestment of dividends and other income but do not account for any transaction, custody, tax, or management fees encountered in real life. To that extent, these index numbers are artificial and cannot be duplicated in real life due to the necessity of paying those transaction, custody, tax, and management fees. Industry and specific sector returns (technology, utilities, etc.) do not account for the reinvestment of dividends or other income. Future events will cause these historical rates of return to be different in the future with the potential for loss as well as profit. Specific indexes may change their definition of particular security types included over time. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of Proffitt & Goodson, Inc. Past performance does not guarantee future results.
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