Think Total Return

Portfolio Planning Article

Charles Schwab & Co., Inc.

Call us at 866-232-9890

Send us an email

Printer-friendly
Type Size: A A A
Email to a friend

Think Total Return
by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc.
August 10, 2006

Reprinted from the July 20, 2006 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

When you buy most securities, your money can grow in two ways: price appreciation, which you realize when you sell, and income payments along the way. This is your total return: the price growth (or capital appreciation) plus the dividend and interest income (or yield).

When forming your retirement accumulation or withdrawal strategy, don't get overly hung up on yield. Remember, it's just one component of return. Regardless of where current yields may be, there is still potential price growth in your portfolio. Combining both components in a total-return approach can help smooth some of the year-to-year variations in your income stream or portfolio value caused by movements in yield or price.

Emulate the pros
The concept of managing a portfolio for its total return, and not just its income yield, is not new. In 1969, the Ford Foundation published its landmark study "The Law and the Lore of Endowment Funds," which concluded that many endowments were suffering by focusing on avoiding losses and maintaining current income. Today, most institutional investors—such as university endowments and pension plans—document and follow a total-return strategy to meet their funding needs, freeing their operating costs from dependence on the vagaries of the market.

Learn how these institutional investors, who must meet yearly pension payments or university operating costs, generate reliable income streams using a total-return approach.

Don't get hooked on yield
High-yield investments often come with multiple risks. We're used to thinking about increased credit risk from high-yield bonds, but what about risks from other high income-generating securities? Loading up on some of the high-yield darlings of 2005 (remember Real Estate Investment Trusts, or REITs, and GM bonds?) could have introduced troublesome asset-class or sector concentrations into your portfolio.

Take REITs, for example. Although appropriate for many portfolios, they should not be used as fixed income substitutes just because they have a high dividend payout. They may introduce equity-like risk, increasing your portfolio's swings. While the S&P 500® Index rose 56% during 1998–1999, the Dow Jones Wilshire REIT Index dropped 19%. Despite entering a period of generally rising returns, REITs lost 15% in April of 2004 before ending the year up 33%.

Taking a total-return approach and using a sustainable withdrawal rate can reduce the risk that you'll run out of money prematurely. (As a general guideline, we suggest withdrawing 4% of your portfolio value in the first year of retirement and increasing that dollar amount for inflation every year thereafter.) Once you're not focusing solely on dividend and interest income to meet your day-to-day expenses, you'll see that cash can be pulled out of your portfolio from dividend and interest income, as well as from periodic rebalancing activities and planned sales. The trick is to withdraw enough to live on and leave your portfolio with the right balance of stocks (for continued growth) and bonds (for stability and income) while achieving a comfortable risk level.

Fight inflation with equities
If you want to increase your annual withdrawals in retirement to keep up with inflation, you would need to grow your existing investments. That would likely mean investing in equities. Although there is no guarantee of future results, you should consider that since 1970, stocks have been the only asset class with the appreciation to outpace taxes and inflation; bonds lost ground.

The S&P 500: Yield vs. total return

Data from Standard & Poor's as of Dec. 31, 2005.

And don't forget that yields can vary widely over time, which could cause a yield-driven investor's standard of living to fluctuate sharply decade by decade. Why would you settle for a meager 2.6% S&P 500 dividend yield in the 1990s when you could have had more by taking some of the capital appreciation that led to an 18.2% total return? However, both components of total return fluctuate over time, as the chart above illustrates. In the 1970s, dividend income made up 71% of the S&P 500's total return, showing the benefit of looking to both sources.

A Schwab Advised Investing™ consultant can help you create an investment policy statement similar to what the pros use—setting out your investment goals and developing a plan to fund your retirement expenses. Taking a total-return approach should help provide you with more stability for spending needs—and greater peace of mind.

Investing in REITs may pose additional risks such as real estate industry risk, interest rate risk and liquidity risk. Past performance is not a guarantee of future results, and your investment results will vary.

Although the information contained herein is obtained from sources believed to be reliable, its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinion are subject to change without notice. No portion of this report may be copied in any manner or form, nor redistributed, without the prior written consent of Schwab. All charts and research have been compiled from publicly available, proprietary and/or licensed data. Past results are not indicative of future performance. Diversification and asset allocation do not eliminate the risk of investment losses.

The S&P 500® Index is an index of widely traded stocks. Indexes are unmanaged, do not incur fees or expenses and cannot be invested in directly.

Sector investing may involve a greater degree of risk than an investment with broader diversification.

When a bond is purchased or sold, Schwab charges a commission, markup or markdown. Individual bonds are subject to the credit risk of the issuer. Changes in interest rates can affect a bond's market value prior to call or maturity. Bonds are subject to credit, interest rate and inflation risks. In addition, bonds incur ongoing fees and expenses.

This report contains viewpoints and opinions on the economy, the markets, and specific companies and securities. From time to time, certain of them may differ from each other. Additionally, Schwab or its affiliates may publish or otherwise express other viewpoints or opinions that may be different from certain of the viewpoints or opinions expressed in these materials. Investment funds and/or separate accounts managed by Schwab or its affiliates may take positions contrary to the information contained in these materials.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, Financial Planner or Investment Manager.

(0806-7120)

Return to Top

Schwab can help

Get a diversified investment portfolio.