Look Beyond Interest and Dividends to Generate Cash Flow

Many investors, whether retired or not, rely on cash from their investment portfolios at some point. This can be entirely appropriate and a great way to put your wealth to work. What is unfortunate, however, is that many investors assume that to generate this cash flow they need a portfolio full of dividend-paying equities or interest-bearing fixed interest investments. Whilst this sort of portfolio will produce regular cash flow, it may also leave you impoverished, if you’re not careful.

Of course, realising regular income from dividends and fixed interest investments sounds great. And it can be an appropriate strategy for a portion of your portfolio. But as a strategy for the bulk of your investable assets, it may well be less appealing because, even though it sounds as safe as can be, it comes with a number of risks.

Fixed interest investments are generally less volatile than equities over shorter periods of time, but they have their own, often overlooked risks. For example, rising interest rates often cause fixed income investments to decline in value. And what happens when a bond you bought 10 years ago that yielded 5 percent per year matures, and a comparable replacement bond yields only 2 percent? This is known as reinvestment risk since when your fixed income investment expires you may not be able to find a replacement investment with similar risk and return expectations. Bonds are also subject to default risk—sometimes the borrower isn’t able to fully repay the lender.

For dividend-bearing equities, there are at least two risks worth considering. First, there’s no certainty an equity will continue paying out dividends at its current rate. Companies can and do often cut dividends when times get tough. There’s also a somewhat more subtle risk. Dividend-paying equities tend to be concentrated in a few areas of the market—sectors such as Real Estate, Utilities, Consumer Staples, some parts of Communication Services and so forth. If you choose to invest only in dividend-bearing companies, you may be under-diversified and have more portfolio risk than you intend.

Perhaps most of all, focusing too heavily on interest and dividends to meet your cash flow needs can limit your potential for capital appreciation. And chances are you need some long term growth in your portfolio.

Homegrown Dividends

“Homegrown dividends” — selectively selling equities for cash flow — can be a more attractive way to generate “income” from your portfolio. One main advantage: Carefully managing an equity portfolio for periodic cash withdrawals can let you more fully capture the long term growth potential of equities. It may also offer substantial tax benefits. Before exploring these benefits more fully, let’s consider two potential misconceptions that can be stumbling blocks for investors.

First, some investors mistakenly assume that interest and dividends are the best and perhaps even the only sources of income from their investment portfolio. This may be because interest and dividends are often treated as income when it comes time to pay taxes, but if you sell equities that money is often treated as a capital gain or loss. It is better, however, both from an investing and tax perspective to be open-minded about where your cash flows come from, even if the source of that cash flow is not designated as income on your tax return. When you pay your mortgage, utility bills or the restaurant tab—no one cares if the money was from a dividend, a bond coupon or an equity sale. You shouldn’t either.

Second, some investors, especially retirees, may be hesitant to sell any assets in their portfolio to generate cash withdrawals. Often the fear is that by selling equities and taking withdrawals you’ll reduce the size of your portfolio (true!) and put yourself on a sure path to running out of money (not necessarily true!). Of course, you’ll need to identify a sustainable level of withdrawals so your portfolio can continue working for you as long as you need it to. If, for example, your portfolio declines by 20% and you take a 10% withdrawal your portfolio would need to increase by 39% just to get you back to where you started! Less understood is the risk that you face if you have a portfolio that focuses too heavily on fixed interest or dividend-bearing equities. Whilst such a portfolio will create regular income, your total return may be lower than with an equity-based portfolio and this can mean that your portfolio may not grow enough to keep pace with inflation.^[i]

Focusing on homegrown dividends lets you stay invested in equities—the asset class with the highest average annualised rate of return. And if you require portfolio growth, equities may be appealing or, quite simply, necessary.  Whilst it is true that fixed interest investments are less volatile in the short term, over longer periods, such as 30 years, equities actually have lower volatility than fixed interest—as measured by standard deviation (a common measure of volatility)—and greater returns.^[ii]

Using homegrown dividends from an equities portfolio to generate cash flow can be a flexible and tax smart strategy. Equities are generally easier to buy and sell than individual fixed interest securities, so you’re able to adjust your portfolio as you need to. If you need to make regular withdrawals, it’s a good idea to keep several months of expenses in cash in your portfolio at all times. This way you won’t be pressured into selling equities each and every month and you can be tactical and selective about what you sell and when. From a tax perspective, homegrown dividends can be also be a win. Capital gains tax on long-term equity appreciation may be lower than taxes on fixed income or on dividends. And if you sell an equity at a loss you may be able to use that to offset realised capital gains. All of this can make selectively selling equities a tax-efficient strategy and one that gives you a greater chance of growing your portfolio.

When it comes to generating income from your investment portfolio, it can pay to think beyond dividends and interest, especially if you have a long investment time horizon and are hoping to grow your portfolio. Stop thinking just about dividends and interest, which might unnecessarily restrict your investment options, and consider homegrown dividends—selectively selling equities to generate cash flows. This can let you flexibly manage your portfolio whilst staying invested in the equities you believe perform best, without being locked into choosing only the ones that issue dividends.

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Fisher Investments Europe Limited, trading as Fisher Investments UK, is authorised and regulated by the UK Financial Conduct Authority (FCA Number 191609) and is registered in England (Company Number 3850593). Fisher Investments Europe Limited has its registered office at: 2nd Floor, 6-10 Whitfield Street, London, W1T 2RE, United Kingdom.

Investment management services are provided by Fisher Investments UK’s parent company, Fisher Asset Management, LLC, trading as Fisher Investments, which is established in the US and regulated by the US Securities and Exchange Commission. Investing in financial markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world financial markets and international currency exchange rates.

[i] Total return measures capital appreciation as well as income (such as interest and dividends).

[ii] Global Financial Data, Inc.; as of 31/07/2018. Average rate of return from 01/01/1950 through 31/12/2017. Equity return based on Global Financial Data, Inc.’s World Return Index and is converted to EUR. The World Return Index is based upon GFD calculations of total returns before 1970. These are estimates by GFD to calculate the values of the World Index before 1970 and are not official values. GFD used specified weightings to calculate total returns for the World Index through 1969 and official daily data from 1970 on. Fixed Income return based on Global Financial Data, Inc.’s Global USD Total Return Government Bond Index and is converted to EUR. Standard deviation is a measure of the dispersion of a set of data from its mean and is used as a measure of risk. The higher the variation in a product’s returns, the greater its standard deviation. Therefore, lower standard deviation is generally preferable.