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Income Investing With a Dash of Total Return

Even dedicated income investors can employ best practices from the total-return world.

During the past few years, we've spent a lot of time discussing the income versus total-return approaches to managing assets during retirement. We've had healthy debates in Morningstar's Discuss forum, and several of you have emailed me to share your points of view.

But the more I hear from you and think about this topic, the more I've realized that the two camps are not that far apart. Total-return investors should absolutely incorporate income-producing securities into their portfolios, as bonds and dividend-paying stocks can confer an invaluable level of stability. Furthermore, income-focused investors, just like the totalniks, wouldn't mind increasing their principal even as they hope to live off their portfolios' current income.

The incomeniks tend to be the most passionate defenders of their strategies, and I won't try to dissuade them from that approach, though I generally favor the total-return emphasis. Finding an investment discipline that you understand and have conviction in can enable you to stick with it in good times and bad. At the same time, however, income-focused investors can and should take some best practices from the total-return playbook. Doing so can help improve their portfolios' risk/reward profiles as well as their tax efficiency. Here are some of the key guidelines to bear in mind.

Don't Forget to Look Down
For any investor, income-focused or otherwise, the most important rule is to balance return potential with safety. A security with a robust yield could be a value trap, a rich payout sitting atop a business or asset that's flailing beneath that attractive veneer. Also stay attuned to the possibility that a company could cut its dividend in the future, as was the case with many financials stocks that boasted robust yields during the 2008 financial crisis. My colleague Josh Peters, Morningstar's resident dividend enthusiast, pays a lot of attention to both issues in his newsletter and in his video discussions with us, and Morningstar's stock and fund analysts also do a good job of red-flagging securities whose enticing yields conceal high risks.

Don't Ignore Asset Allocation
Some investors think that employing an income approach gives them license to ignore the principles of asset allocation: If a portfolio of dividend-paying stocks is meeting their income needs, why should they care if it's not diversified among asset classes? I'll concede that some dividend-paying stocks have even higher yields than bonds right now, and that probably is a decent signal that the former are undervalued and the latter overpriced. And yes, higher interest rates--when and if they ever materialize--would likely roil bonds more than stocks.

But even if you run a portfolio that's focused on dividend payers, a relatively small position in bonds will work wonders on the stability front. For example, a portfolio composed of high-dividend-yielding stocks and preferreds would have lost about 32% in 2008--less than the broad equity market, but a shocking loss nonetheless. However, had that same investor staked a measly one fourth of the portfolio in a bond-market index fund, the 2008 loss would be reduced to 25%--still high, but headed in the right direction. And as I've noted in another article, the magnitude of bonds' losses, even in a tough bond-market environment, will be much lower than is the case for stocks. The diversification conferred by asset allocation has rightly been called the only free lunch in investing; why shouldn't income investors queue up for it, too?

Employ a Baseline Cash Fund
For retirees, my usual advice is to maintain a cash account that amounts to one to two years' worth of living expenses, then plan to periodically fill it up as you deplete it. That common-sensical strategy works for both income and total-return investors. Although total-return investors might fill up the cash sleeve of their portfolio by selling off chunks of their bond fund and moving it to cash, income investors might use dividends and bond income to fill up the cash portfolio on a regular basis. Why employ a cash fund rather than just living off your dividend checks and bond income? Having a cash fund enables income-focused investors to plan and stay a step ahead: Even if dividend cuts or declining interest rates cause income to decline in a given year, you can rest assured that you have enough cash on hand to pay the bills; you won't have to scramble around to make up the shortfall on the spot.

Don't Be Allergic to Selling
One income-focused Morningstar.com reader wrote to tell me that he's "nearly allergic" to the idea of selling securities to meet living expenses. But even dedicated incomeniks should stay opportunistic and not shut themselves off to liquidating securities if doing so helps lighten their tax burden or improves their portfolios' risk/reward profiles. Selling can make sense, for example, if you have losers in your portfolio and you want to harvest those tax losses.

Of course, it's possible to plow that money right back into the same asset class from where it came (assuming you take care to avoid the so-called wash-sale rules). But you could also use the proceeds from your sale to pad your cash account (see preceding point). Ditto if you've just gone through the rebalancing process and you've trimmed some winning stock holdings: You can plow that money into your cash holdings to top them up.

A version of this article appeared Sept. 1, 2011.

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