BUNK 29
INTEREST PAYS DIVIDENDS
Raise your hand if this applies to you: “I need my portfolio to kick off some reliable amount of cash flow to partially or wholly fund living expenses in my retirement—whenever that is.”
You’re not alone. With firms veering away from pensions, many investors have saving for retirement as a major goal. (Another way to say it: For many, Social Security won’t be enough, and those who plan on relying on it alone will likely be in a world of hurt.)
Now, raise your hand if you think, once you retire, you need a portfolio full of dividend-paying stocks and interest-bearing bonds to provide that income.
You’re also not alone—it’s a very common view. But this is one dangerous, poverty-inducing bit of easily debunked bunk.
Or maybe not—maybe you have a $10 million portfolio and require only $50,000 a year. And maybe you don’t care if the $50,000 isn’t inflation-adjusted. Or, if you don’t have $10 million, maybe it doesn’t matter to you if your assets dwindle because of reinvestment risk or your high-dividend stocks suddenly stop paying dividends.
But chances are, if you’re reading this book, you don’t want your assets to stagnate or deplete—which is what can happen if you focus solely on coupons, interest, and dividends. What happens when the bond you bought in 2000 that yielded about 6.7 percent per year matures, and a comparable replacement bond in 2010 likely yields about 3.5 percent?1 And what happens if that stock paying an 8 percent dividend cuts it to 2 percent in tough times? Or zero? That can happen—and that’s probably not what you were banking on. (Pun intended.)
And the $10 million question: What about inflation over the rest of your long life?
It’s simply not true that interest and dividends are necessarily a “safe” way to get retirement income. But how else can investors get cash from their portfolios? You don’t want to—oh, no—sell stocks, do you?

Homegrown Dividends

Sure. Why not? First, many folks mistakenly assign themselves an inappropriate asset allocation, partly because they think they must be “conservative” (Bunk 3)—but also because they think they need the dividend and interest income for cash. This confuses “income” with “cash flow.” Interest and dividends are what’s traditionally called “income.” Even the IRS looks at interest and dividends as income—and tax you for it. But, after tax, you should be agnostic about the source of your cash flow.
When you pay your mortgage, electric bills, or the restaurant tab—no one cares if the money was from a dividend, a bond coupon, or a stock sale. You shouldn’t either. And because tax treatment for long-term capital gains can be cheaper than for interest and dividends, which are taxed at your (likely) higher marginal “earned” income tax rate (based on 2011 law), you can get more bang for your portfolio buck from selling stocks—if done wisely. And that means you can, if appropriate, keep more of your money in an asset class that has a higher probability of yielding better long-term returns. (See Bunks 2 or 3.)
All this presumes you have a long life ahead of you whether retired or not, which most folks of normal retirement age do today (again, Bunk 3). Say you have $1 million saved, and you want $40,000 a year to support your lifestyle. (More than 4 percent distributions and your depletion risk increases.) Maybe you want even distributions into your checking account each month—about $3,333, give or take. It’s easy—just keep about twice that in cash in your portfolio at all times, or about $7,000. Having that small amount in cash won’t materially impact performance in a rising stock market, and in a falling stock market, you needn’t rush around to sell stocks at a relative low.
Instead you can be tactical about what you sell and when. You can sell “down” stocks as a tax loss to offset gains you might realize. You can pare back over-weighted positions. And you may even have, quite by happenstance while seeking total return, some dividend-paying stocks to add some cash, but then that’s a decision about whether you think they’re the right stocks to hold, and you aren’t handcuffed to them just because of the dividend. Like any other investing category, high-dividend paying stocks cycle in and out of favor, so sometimes it makes sense to hold more and sometimes less. As a category, they tend to do well when other so-called “value” stocks are doing well and do badly when so-called “growth” stocks are the fad. (See Bunk 10.)
I call raising cash this way “homegrown dividends.” It’s how my firm does it for many of its clients. It’s a tax-efficient way to generate cash flow and has the additional benefit of keeping you optimally, appropriately invested—aimed at investing for your unique time horizon.
So stop thinking “income” and start thinking “cash flow.” Be cash flow agnostic.
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