When you hear the word “diversification” in the context of investing, one thinks of owning multiple holdings across asset classes, geographical locations, and industry sectors. The concept of diversification also applies to the sources of cash flows that are generated from an investment portfolio. Michael Kitces, a well-renowned author, and industry thought leader, suggests that there are 4 pillars of retirement cash flow that can come from an investment portfolio: interest, dividends, capital gains and principal.
The biggest contributors will vary from year to year depending on market conditions. In a strong bull market, capital gains may contribute the most; when interest rates are high, interest income may be the largest contributor; and in down markets, tapping principal may be the best source of cash flow as it will enable you to leave the rest of the portfolio invested until the market rebounds.
The Problem with Focusing Only On Interest and Dividends
Many people simply rely on the interest and dividend income generated in a portfolio to supply their cash needs. This can result in a portfolio being much riskier than is appropriate. For example, during the past several years when interest rates have been at historic lows, one would need to invest in lower quality and/or longer-term bonds in order to get the targeted income solely from bonds. Or for those who solely focus on dividends, the dangers of this strategy presented themselves when financial stocks, which are typically high-dividend payers, fell significantly in value during the 2008 financial crisis. Another risk associated with solely focusing on dividends and interest for income, ignoring capital gains and refusing to touch principal is that one could be living significantly below their means.
Many people simply rely on the interest and dividend income generated in a portfolio to supply their cash needs. This can result in a portfolio being much riskier than is appropriate. For example, during the past several years when interest rates have been at historic lows, one would need to invest in lower quality and/or longer-term bonds in order to get the targeted income solely from bonds. Or for those who solely focus on dividends, the dangers of this strategy presented themselves when financial stocks, which are typically high-dividend payers, fell significantly in value during the 2008 financial crisis. Another risk associated with solely focusing on dividends and interest for income, ignoring capital gains and refusing to touch principal is that one could be living significantly below their means.
Prescription for Success
Embrace the fact that your investment portfolio has multiple sources of cash flow that can be relied upon. Appreciate that those different sources will each contribute to your total cash flow in different ways under different market conditions. Doing so will help to ensure that you maximize both the cash flow potential of the account and the portfolio’s longevity without assuming more risk than you are comfortable with or that is appropriate for your situation.
Embrace the fact that your investment portfolio has multiple sources of cash flow that can be relied upon. Appreciate that those different sources will each contribute to your total cash flow in different ways under different market conditions. Doing so will help to ensure that you maximize both the cash flow potential of the account and the portfolio’s longevity without assuming more risk than you are comfortable with or that is appropriate for your situation.