Financial Update - September 2019
Welcome to the third edition of our monthly newsletter. As financial markets appear to have settled down over the past few weeks, we thought it may be a good time to get back to basics and discuss income and dividends.
Financial Portfolio Planning
For all our clients we take a clear consistent portfolio management approach. More specifically, there are three fundamental objectives that we as your trusted advisers and ultimately your wealth managers need to satisfy. These include:
Firstly, we need to ‘protect the portfolio’s capital’.
Secondly, we need the portfolio to 'generate income.'
Finally, once a portfolio's capital is preserved and income is being generated, we then strive for 'portfolio growth'.
In today’s low interest rate environment, investors are increasingly looking for ways to improve the current yield/income on their portfolios. There are a variety of reasons individuals might want more income. For example, retirees and other income-oriented investors like to have higher dividends coming in to help cover portfolio expenditures and pension payments. Some believe that stocks with higher yields have higher expected returns.
The preference individuals have for dividends is nothing new. Investors have long preferred investments for higher yields, especially those that have a long history of paying continuous or growing dividends. And with interest rates at historic lows, it makes sense, doesn’t it?
Unfortunately for investors, there is no evidence that dividend-based strategies are beneficial. In fact, the preference of investing for high-yielding stocks is inconsistent with financial theory. For example, stocks with similar exposures to common risk factors like size, value, and profitability have approximately the same returns regardless of whether or not they pay a dividend.
One possible explanation for the preference for dividends is that they offer a sort of hedge against price declines. The thinking is that the dividend should provide a cushion against falling values, but this logic ignores the fact that when a dividend is paid, a company’s value should fall by the exact amount of the dividend. In other words, a dividend is not free money—it is a choice a company makes to return capital to its shareholders.
What is especially puzzling about the preference for dividends is that taxable investors should favour selling shares for cash flow rather than receiving dividends since this often results in less tax. Unlike a dividend, which is fully taxable when paid, when shares are sold, taxes are due only on the portion of the sale representing a gain. Additionally, 'specific lots' of shares can be sold to minimize the gain.
It is also important to note that expressing a preference for dividends in one’s portfolio will result in a less diversified asset mix. Consider that only about 60% of all listed companies around the world pay a dividend. Therefore, this dividend preference may result in a much less diversified portfolio with far fewer holdings than investing in all companies in the market. Less diversification means greater volatility, which is not advisable without compensation in the form of higher expected returns for the increased risk.
This is why Barwon Financial Planning follows a total return approach to managing your portfolio rather than an income-based approach. For clients who need regular income, we sell shares as needed to free up cash. Additionally, we allow for other planning strategies such as annuities and portfolio ‘bucketing’ to manage income needs. By managing cash flow in these ways, we keep your portfolio fully diversified and properly allocated to the various factors of higher returns. Please let the team know if you have any question.
As always, thank you for your continued trust and confidence.