The Income Investing Fallacy

I need income because I’m not getting a paycheck!

Savers aren’t getting the income they need!

The mania must end. Let’s talk about why the need for income is a fallacy.

Let’s Talk About Joe.

Joe is a 61-year-old retiree. He has been savvy in life so far. He was able to invest his proceeds from working in both a diversified portfolio and in building a small house rental operation. Joe has moved to Florida. He’s happy there and generally does not care to operate his rental operation in New England any longer. Reasonably, he is divesting his real estate portfolio. Divesting the real estate comes with some apprehension because Joe and his wife have subsidized at least half of their lifestyle from rental cash flow. He cannot access Social Security yet and understands it’s likely better to delay it too. Joe believes he has a cash flow problem.

Let’s Make Some Assumptions!

1)     Joe faced this life situation 10 years ago in 2011.

2)     Joe sold his rental portfolio to net $1 million

3)     Joe can buy Verizon (VZ) or Alphabet (GOOG) and those are, for purposes of this example, his only choices. (Relax Twitter, I know this is simplified.)

4)     Verizon had an average dividend yield of about 5.5% in 2011

5)     Google did not pay a dividend

What will Joe do?

In his mind, he needs to replace his lost rental income, so Verizon is very attractive vs. Google. He can collect the 5.5% yield which is about $55,000 a year which replaces his lost rental income. He understands that he’ll pay approximately $11,000 a year in income taxes. It trades at a P/E ratio lower than the market. The company is a staple so he can sleep at night. Verizon looks very tempting.

Google does not pay a dividend at all. It is a tech company that Joe understands to be more volatile than consumer staples. The P/E ratio is higher than Verizon’s. Google does not seem as appealing to Joe.

Joe is on the cusp of making a very big mistake.

Joe is concentrating on income, but income is only a part of the return of a stock. A stock can appreciate in value as well. In fact, with the benefit of hindsight, we know that Joe’s portfolio value in 2021 after drawing $55,000 a year would be $1.6 million for Verizon and $7.2 million for Google.

But I Need Cash Flow Now!

Joe thinks he needs cash flow like his rental properties; however, Joe does not need cash flow, Joe needs liquidity. In fact, we know that if he receives $44,000 after taxes every year, he will be happy. Joe can get that $44,000 by simply selling some Google every year. The dividend is not necessary!

I’ll Need to Take Capital Gains by Selling Every Year

Yes, Joe will need to take capital gains by selling every year, but it is likely the same tax rate or lower that is paid on dividend income. Joe does not have control over the timing of those taxes with dividends and he has some control as to when he takes the capital gain.

Why Does the Business Media Concentrate on Income?

It’s simple and easy to understand. Ultimately, advisers often want to appease clients rather than coach them. Fund providers are more than willing to supply the product to feed that impulse. I do not want Joe to make this huge mistake, and neither should you.

Bottom Line

Do not worry so much about dividend yields or interest rates of your investments. What is important is the total return of your investments (yield plus price appreciation). Dividends can be great, but there is more to finding a good investment than by glancing at the dividend. Now you know and won’t be Joe!

Endnote: In this example, Verizon and Google were not intended to be investment recommendations and are only intended for illustrative purposes in the hypothetical scenario presented above.  Investment recommendations depend on individual risk tolerance and investment objectives.  Consult your financial planner and/or tax advisor to obtain competent counsel on financial matters.