Noticing that all our other lines were busy, I picked up the ringing telephone. Anne Singleton, a stranger to me, announced herself and indicated that she was "concerned about her husband." I asked a few questions to determine whether she realized we were financial advisors, not psychologists; I thought maybe she had dialed the wrong number! It turned out that Tom, the object of her concern, had accepted an offer to retire next June. This reportedly "really nice guy" had, it seems, become a first class crank as he watched his 401(k) shrink during the past year. The shrinkage and the crankiness seemed to be increasing apace, according to Anne; she mumbled something about a 40% loss, which gave me an idea of what the portfolio in question looked like. Did I think I could help? I assured her that I would try.
When the Singletons visited our office a week later, Tom did, indeed, seem like a really nice guy. Yet he was clearly embarrassed that Anne had "dragged him" to see me, and he was more than a little defensive when I probed with questions about his investment history. Because I have seen this situation so often lately, I realized that the apparent failure of his investment strategy so close to his retirement date was causing a storm of anxiety and confusion within Tom. The anxiety concerning his economic future is easy to understand. Less obvious, until you have observed it in many cases, is the nature of his confusion.
Tom Singleton is a very accomplished microbiologist with an international food processing company. Like many high achievers in the professions, he had become accustomed to success; his adult life experience has been a steady stream of challenges that eventually yielded to his creativity, study and diligence. His apparent failure to build what he considered an adequate nest egg before retiring was devastatingly inconsistent with his professional achievements.
To make matters worse, Tom was mentally and emotionally conflicted about the best way to solve his investment problem. His practical side demanded that he stop the bleeding, while his ego whispered that the only way to "win" was to stay the course until stocks came back. He felt paralyzed. And in his mind, his otherwise successful career was about to end on a terribly sour note of failure. I assured Tom that the portfolio reversals he had experienced the last several years were causing the same sort of anxiety for many about-to-retire, highly successful professionals. "Your experience and your temporary feeling of indecision are entirely normal," I said, "and I'm sure that together we can get your retirement plans back on track."
We did some back-of-the-envelope calculations and determined that, in fact, the Singleton's remaining $1 million of investments plus their Social Security income and a small pension would be more than adequate to the lifestyle that they were planning. However, I pointed out, if Tom stuck to his 80% equity allocation and stocks didn't cooperate pretty soon, their future could get a little dicier.
"I think we should restructure your portfolio to put more emphasis on current income," I said matter-of-factly. His body stiffened visibly, and from the look on his face you'd think I had taken away his car keys and consigned him to a nursing home. An aggressive portfolio, so productive in the 1990s, seems to have become for Tom not only a vehicle for prosperity but also a symbol of virility. He clearly did not like the direction I was suggesting. So, thinking that this professional researcher would appreciate some actual data, I shifted into my investment history monologue.
Dividends In Transition "Tom," I said, "there are some very strong crosscurrents in the securities markets today. Investment professionals are quite divided about what lies ahead. We are coming off a period of extraordinary appreciation in the price of stocks, as you know from your own experience. In the five years 1995 through 1999, the average total return on large company stocks was an astounding 29% a year. This is nearly triple the 10.2% average return from 1926-1994. For a while, it appeared that U.S. economic growth was shifting onto a faster track because of new technologies, which partly explains the increase in stock prices. But subsequent events have revealed that the business cycle and long-term growth constraints are still forces to be reckoned with. Instead of the so-called 'New Economy,' we are stuck with same-ol', same ol'. And stock prices are in the process of adjusting to this reality. It may require a few more shabby years for the long-term average equity return to revert to the 10% mean. "Something that is amazing to me about that 10% average total return figure over all those years is that half of it came from dividends! During the 1990s, we all got used to an environment where dividends were a meaningless part of our stock market returns. Appreciation was everything. But it is starting to look like that was an aberration.
"Remember the old saying, 'A bird in the hand is worth two in the bush'? This is the philosophy of risk espoused by those investors who place more importance on receiving upfront dividend payments than they do in the possible growth of the market value of their stocks. It represents a mild skepticism, a "show me" attitude with respect to promises of future returns. Over the years, investor attitudes have cycled between optimism and skepticism; between choosing one bird in their hand over the two in the bush that they might be lucky enough to capture if things work out.
"As recently as the early 1980s, dividend yields were between 5% and 6%. Around 1985, American investors began to accept capital appreciation as a substitute for cash dividends," I continued. "Corporate earnings growth was actually rather ordinary by historic standards, yet corporations gradually began to retain a greater percentage of their profits and to pay out a decreasing portion to shareholders. Investors, perceiving that their portfolios were increasing in market value, did not protest the diminishing cash payouts. At the peak of the bull market in stocks, the dividend yield on the S&P 500 had fallen to almost 1%!
"Today, despite a huge decline in stock prices, the dividend yield on the S&P 500 is still a paltry 1.6%, compared with a long-term average dividend yield of between 4% and 5%. It seems to me that this low yield suggests a continuing investor disdain for upfront cash returns. And the P/E ratio is still quite high at between 20X and 30X, depending on what earnings numbers you prefer, implying continuing investor enthusiasm regarding growth potential.
"Some highly regarded academics and a number of investment professionals such as Warren Buffet, Jack Bogle and Bill Gross are convinced that from a starting point of a high price-to-earnings and a very low dividend yield, we should expect stock returns over the next decade as low as 5% or 6%. In effect, they are suggesting that the appreciation experience of the 1990s was an aberration and that equity returns are in the process of reverting to the long-term mean. After all, economic growth doesn't look any better than it has over the last 50 years, and actually could slow down due to lower workforce growth, record debt and global competition.
"What I am trying to say, Tom, is that building a portfolio with an above-average upfront cash return may turn out to be the smartest thing an investor can do for the next few years, whether that investor is retired or in the middle of his accumulation years. I think the odds favor sluggish growth while our economy adjusts to its debt burden and to the permanent shift of manufacturing activity to the Orient. If that turns out to be the case, appreciation will be hard to come by and the stock market may begin paying a premium for dependable cash income. That's why I want to restructure your portfolio to stop the bleeding and to raise your return potential. I am not proposing that we build you a widows and orphans portfolio. I am suggesting a way to profit from a long-term shift in investor preference that I believe is taking place." Tom seemed to relax just a little.
Diversifying An Income Portfolio I went on to describe for the Singletons that an income-oriented portfolio needs diversification in much the same way that a growth portfolio does. We diversify a growth portfolio because we realize that some of the companies we invest in will disappoint relative to our expectations. In a similar fashion, it is healthy to diversify our income investments because some of the ones we choose are probably going to experience problems. That's life.
There are two basic kinds of income investments, of course: debt (bonds that pay interest) and equity (stocks that pay cash dividends). Bonds have credit risk and interest rate risk; we need to diversify both of these. For our dividend-paying stocks, we are most concerned with the possibility that business pressures will require some of our companies to cut or eliminate their dividends.
Tom's portfolio was "growth-oriented." I actually think that this is a very misleading description of the investment style that pays between 40 and infinity times earnings for minority equity positions in unproven businesses or companies with a short performance history. I call this a "hope-oriented" portfolio because you hope somebody will one day pay you more for your shares than they cost you. When my clients are about to retire and begin drawing cash from their portfolio, I prefer to have more of their expected return in upfront cash receipts and less of it based on hopes. Cash income is "for sure," I tell them; appreciation is "maybe."
How much cash can we get upfront in a diversified, income-oriented portfolio? Close to 5%. My general guidelines for structuring such a portfolio follow. The exact percentages vary depending on the client's withdrawal needs and on yields available at the time of investment. Stocks: 30% with a dividend yield of about 3.2%. This is twice the dividend yield of the S&P 500. I mix gas and electric utilities (5% yield), a mortgage REIT (10% yield), a regulated investment company (9% yield), several individual stocks of companies with strong market share (2.5% yield) and several deep-discount value funds (1.5% yield). Cash: 5% with a yield of 1.5%, just to have liquidity to accommodate retirement withdrawals. If money fund yields rise enough, we would be comfortable with a little more cash. Short-term (two to three year) bonds: 20% with a yield of 5%; primarily A-rated corporates, using low-cost mutual funds. Medium-term (four to ten year) bonds: 25% with a yield of 6.6%; primarily A and AA corporates (5.8% yield), using low-cost mutual funds. Mix in a closed-end preferred stock fund (7.8% yield) that has interest sensitivity similar to a medium-term bond, a little bit of "conservative" high-yield fund (10.5% yield), and 10-year TIPS (5% yield, depending on your CPI expectations). Long-term (10 to 25 year) bonds: 20% with a yield of 7%; primarily A and AA corporates, using low-cost mutual funds. Mix in a BBB fund (8.5% yield), and 20-year Treasury strips (5.5%).
I showed the Singletons that their $1 million portfolio arranged along these lines would throw off just over $50,000, or 5% in annual cash return. In a world of 1.5% inflation, this represents a 3.5% real cash return, which is double the historic real return from long-term Treasuries. It is quadruple the cash yield from their current portfolio.
This portfolio has a meaningful 30% equity stake in solid American businesses to provide growth potential; if stock values should become more attractive in the future, we can always raise this allocation. The fixed-income investments are arrayed across the duration spectrum to soften the impact of possible extreme interest rate shifts in either direction. And credit risks range from Treasuries to junk bonds; because Treasury yields have declined this year, we are currently emphasizing investment-grade corporate issues, where the spread over Treasuries is higher than usual.
Choose Your Bird In the last few years of the 20th Century, investors traded their bird in the hand for the prospect of two or more lurking in the bush. Unfortunately for them, the birds got away. Or maybe they were never in the bush in the first place. Now those investors are stuck with a hope-oriented portfolio that still pays only 1.6%.
"The choice you need to make, Tom, is the same choice facing the average American stock investor. Do you reduce your bet on possible future appreciation in favor of a 5% upfront cash return? Or do you keep shaking that bush, hoping to bag a couple of fat ones?" "Mike, you make a lot of sense. And, believe me, I would feel a lot better if we could stop the bleeding. But you know what bothers me more than giving up on growth?" Tom asked. "I'm worried about the possibility of increasing credit problems in the economy. More than half the portfolio you described is invested in corporate bonds of one kind or another. Seems like every week we read about a downgrade or a default."
"You know, Tom, you're right. The condition of the nation's balance sheet is a legitimate concern. If you could earn what you need with a laddered Treasury portfolio, I'd be the first to suggest it. If I thought you could earn 10% a year from stocks over the next few years, I wouldn't be talking up income. As to the credit risks, the first line of defense is diversification; you'll have five or six mutual funds with literally hundreds of different companies' bonds; a few downgrades will be insignificant. And think of it this way. If we have an environment in which downgrades are rampant, would you rather be a bondholder or a stockholder?"
Like most of our retired clients, Tom (with his wife's encouragement) decided it was time for him to become a bird-in-the-hand kind of guy. I think he will be pleasantly surprised with the results.
J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.