{"id":130458,"date":"2022-03-25T11:38:00","date_gmt":"2022-03-25T15:38:00","guid":{"rendered":"https:\/\/ibkrcampus.com\/?p=130458"},"modified":"2022-11-21T09:53:00","modified_gmt":"2022-11-21T14:53:00","slug":"who-needs-dividends-and-interest","status":"publish","type":"post","link":"https:\/\/www.interactivebrokers.com\/campus\/ibkr-quant-news\/who-needs-dividends-and-interest\/","title":{"rendered":"Who Needs Dividends and Interest?"},"content":{"rendered":"\n

The post “Who Needs Dividends and Interest?” first appeared on Light Finance Blog<\/a><\/em>.<\/p>\n\n\n\n

In another world, seemingly long ago (i.e., January of 1990) the yield on the 10-Year Treasury was 8.20% while the dividend yield on the S&P 500 \u2013 which varies with market valuations \u2013 stood at 3.28%. In this world, a retiree with a $1,000,000 nest egg could have invested their portfolio is 10-Year Treasury bonds \u2013 a technically risk-free asset \u2013 and lived comfortably off interest income of $82,000 per year. An investor more comfortable with risk choosing to invest in stocks could have expected income of $32,800 per year, but would principally have relied on capital appreciation to meet their retirement goals; which necessarily involves more risk.<\/p>\n\n\n\n

As the above illustration highlights, cash flow from low risk investments was previously sufficient to meet investors\u2019 lifestyles. Increasingly, however, investors have had to rely on price appreciation to finance their needs. As of June 2021 the 10-Year Treasury yield was 1.52% while the S&P 500 dividend yield was 1.37%. As the below plot demonstrates, it is increasingly common for the S&P 500 dividend yield to exceed treasuries. Interest and dividends at such miserly levels is unlikely to address investor\u2019s income needs. This has left many wondering how they can increase cash flow or what other options are available to them.<\/p>\n\n\n\n

\"\"
Source: Federal Reserve and St.Louis FRED Database<\/a>, Quandl<\/a><\/figcaption><\/figure>\n\n\n\n

In this post, we\u2019ll examine the issue of investor cash flow and whether it\u2019s the appropriate paradigm for assessing your investments.<\/p>\n\n\n\n

Income or Cash Flow?<\/h3>\n\n\n\n

There is a conceptual difference between income from a portfolio and cash flow. Income refers to cash payments received from the portfolio (i.e., interest and dividends). Cash flow refers to the capacity of your portfolio to provide you with a consistent paycheck which may be derived partially from interest or dividends, but may also come from the principal.<\/p>\n\n\n\n

Understanding this distinction is subtle, but important. As an investor, it\u2019s generally more appropriate to focus on the total return of a portfolio and the sustainable withdrawal rate rather than the myopic view of yield.<\/p>\n\n\n\n

Understanding Interest and Dividends<\/h3>\n\n\n\n

Dividends from Stock<\/h4>\n\n\n\n

A common misunderstanding that I encounter with respect to dividends is that investor\u2019s often view them as \u201cfree money\u201d. Investing in dividend stocks won\u2019t necessarily create excess shareholder wealth over time as a stock\u2019s price usually declines on the day that it begins to trade ex-dividend (i.e. without its dividend). The reason for this is intuitive: a company has a certain amount of cash on its balance sheet which is reflected in the value of its equity, once that cash is paid out the equity necessarily has to decline to offset the change in assets. The below chart depicts this visually. It\u2019s important that your dividend strategy be analyzed from a total return perspective accounting for both income and capital appreciation.<\/p>\n\n\n\n

\"\"<\/figure>\n\n\n\n

Interest from Bonds<\/h4>\n\n\n\n

You encounter a similar issue with bonds. While bonds generally tend to be lower risk than stocks, in many ways they are also more complex and investors generally have less direct experience with them.<\/p>\n\n\n\n

In order to understand bonds properly, I\u2019m going to have to introduce a little jargon:<\/p>\n\n\n\n