Income Investing: You Know…For Kids.

Originally published: September 8th, 2015

If you’ve ever talked to a money manager, or read their blog, or sat through your HR department’s presentation on why you should contribute to your 401K now rather than later, you’ve probably heard something along the lines of the following:

“The longer you have until retirement, the more risk you can have in your portfolio.”

Now this is not exactly dogma from the Church of Buy and Hold, although plenty of Buy and Holders would probably happily ascribe to this nearly universally accepted “truth”. This philosophy is deeply ingrained in our modern financial system’s paradigm. It is constantly regurgitated by media, financial analysts and advisors, retirement fund literature…really by just about anyone who has ever given financial matters even the slightest bit of thought or consideration.

In fact there is a whole industry of mutual funds that have arisen called “target date funds” that automatically change the allocation of investments from “growth” to “income” as the “target date” of the fund approaches. Nearly half of the investment options in my company’s 401K plan are “target date” funds.

There are very few people that see an issue with what has essentially become an axiom of retirement investing.

The axiom is based on the presumption that you can either have growth or you can have income. Growth carries more “risk”, because anything that has a big potential upside carries with it a big potential downside. Income is “safe” in the sense that there isn’t as big of a potential downside, but you have to trade off the upside potential to get it. So if you’re older and closer to or at retirement, your portfolio should emphasize income, because 1) you can’t afford too much downside potential, and 2) you need income. But if you’re young and invested in growth 1) you presumably have other sources of income and 2) if the market has a bad year, you can just wait for it to come back up and you’ll reap the upside potential whenever it finally comes around.

Well I say that’s total baloney.

First of all fundamentally sound growth oriented investments shouldn’t carry more “risk”. They are more likely to be volatile. That is really a matter of semantics, but it highlights the flaw in the thinking. The reason “risk” and “volatility” have become synonymous in financial parlance is that most of us can’t really have a holding period of forever. At some point we need the paper gains to become real, and support us in our financial independence. The “risk” of volatility is that when the day of reckoning is here, we’ll be in a downswing of the cycle.

Second of all income and growth aren’t mutually exclusive at all. In fact, if you take the income and reinvest it, the result is COMPOUNDING GROWTH, which as we all know is one of the holy canons of the Church of Buy and Hold.

So if you have a long time until you retire, you have that much more time for the power of compounding growth to supersize your portfolio. I say don’t waste that time waiting for volatile investments to hopefully come back up. Use that time for conservative investments to pay you cash money that you can use to make more conservative investments that pay more money, and so on.

Let’s say I make an “aggressive” growth investment with $10,000 dollars and hold it for 10 years. The investment has a lot of growth potential but generates zero income for me.

Year 1: Up 18%

Year 2: Up 28%

Year 3: Up 13%

Year 4: Up 4%

Year 5: Down 20%

Year 6: Up 29%

Year 7: Up 12%

Year 8: Down 30%

Year 9: Up 28%

Year 10: Down 9%

For those of you keeping track at home, at the end of Year 10 my investment is worth $16,728.26 and I have a paper gain of 67.28%, which is an annualized growth of 6.7% per year. That’s pretty damn good, and totally within range with what we’d expect from an aggressive growth investment. Good on me for not panicking and selling in Year 5 when I lost 20% of the imaginary paper value of the investment.

But it sure would have been nice to sell at the peak of Year 7 when I was up over 100% which at that time represented a 15% annualized return.

Thou can’t time the market, so thou shalt not try to!

But I have to time the market somehow…I’ll either have good timing or I won’t, but I have to time it. At some point, I will need income. I can’t pay my bills with paper gains, and this investment generates only paper gains.

Let’s go back in time and change the strategy. This time I invest $10,000 in an investment with a 4% yield. The 4% yield will grow at an average annual rate of 6.6% per year (some years more some years less…but it always grows.)

I reinvest the income I get. Reinvested income also starts out with a 4% yield that grows at the same % rate of subsequent years.

Year 1: $400.00 of income.

Year 2: Yield grows by 8%. $448.00 of income.

Year 3: Yield grows by 4%. $483.20 of income.

Year 4: Yield grows by 7%. $535.00 of income.

Year 5: Yield grows by 10%. $607.72 of income.

Year 6: Yield grows by 3%. $647.11 of income.

Year 7: Yield grows by 12%. $746.55 of income

Year 8: Yield grows by 6%. $815.74 of income.

Year 9: Yield grows by 9%. $915.02 of income.

Year 10: Yield grows by 7%. $1,007.27 of income.

For those of you keeping track at home, I’ve collected $6,605 of income in the ten years I’ve held the investment (6.6% annualized gain). The paper value of my investment is completely irrelevant, but let’s just says for argument’s sake that I have a paper loss on the $16,605 invested, so market value of the investment is…oh I don’t know…say $15,721. So I have a little less imaginary money than I would have after scenario 1’s roller coaster, but if I add Year 10 income I have the same amount of total capital. It just happens that $1,007.27 of it is real money.

Plus I’m already earning over $1,000 per year in cash money without having to sell anything. They just mail me the check.  That $1,000 check represents a 6% “invested yield”, meaning I’m getting 6% of my total investment ($16K) back every year in income, even though the market yield of the investment, by definition of the thought experiment, is 4%.

Now what happens in years 11-20? Who the hell knows?

The imaginary paper value of my aggressive growth investment will probably continue to swing wildly, with an overall uptrend. And my income growth investment will probably keep paying me more and more cash money each year.

When do I retire? Who the hell knows?

In scenario 1 hopefully it’s during an upswing, and I can convert my imaginary paper gains into real gains and then start from square one earning 4% income with the total.

In scenario 2 it doesn’t matter when I decide to start spending my income rather than reinvesting it. I’ll already be enjoying a higher invested yield than 4%, and I never have to sell anything at just the right time. Thou can’t time the market, so thou shalt not try to! Yes, oh Oracle. I shall not try to!​

 

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