One of the enduring concepts used by successful retirees and endowment funds alike is the idea that portfolio income is what pays the bills, not portfolio market value. Market values change from day to day and minute to minute. As we’ve written before, “Own the orchard for the fruit crop.” It helps one’s sanity to focus on the fruit crop (portfolio income), not the value of the orchard (market value.)
Imagine a company, XYZ Widgets, whose shares trade for $100 per share and pay annual dividends of $3 (a yield of 3% annually on the stock price.) The price of XYZ stock can go up or down in the short term, but historically there is little correlation between changes in the market price and changes in the dividend.
Let’s imagine that XYZ stock falls to $50. While companies may sometimes cut dividends they are often reluctant to do so, so XYZ may continue paying $3 per share. Despite the drop in stock price, shareholders would still get the same $3 with which to pay their bills. In fact, XYZ may then be an even better prospect for income investors: at $50 a share, that $3 dividend now gives them a 6% annual yield on their cost.
The same applies to bonds and other income-generating investments. A 5% bond issued at full price may be sold off down the road for cheaper if bondholders are worried about the company’s prospects for making good on their debts. If you bought that 5% bond for 50 cents on the dollar you would receive the same amount of interest, but now it would be equivalent to a 10% return on your investment each year. If the company recovered and was able to pay full price at maturity, you would receive 100 cents for every 50 cents worth of bonds you bought at a discount.
This arithmetic is one reason why investors who “buy low” often have an edge. A market downturn can have alarming effects on your retirement savings. But while the purchasing power of your retirement funds may go down, falling prices also allow you to buy income investments at higher yields.
There is no guarantee that you will be able to find high quality investments at such steep discounts, or that discount investments will turn out to be high quality. These examples are intended to illustrate the arithmetic of portfolio income, not as advice to any individual to buy a specific investment.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you discuss your specific situation with your financial advisor prior to investing.
The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.
Investing involves risk including loss of principal. No strategy assures success or protects against loss.