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June 2, 2019 | By Michael Kimmel, CFP®
Many investors utilize income-producing holdings such as dividend-paying stocks and/or bonds to generate cash flow within their portfolio. When analyzing the performance or appropriateness of these holdings, it is important to take into account not only the income generated, but also the change in principal value. The method of measuring performance that takes both income and capital appreciation/depreciation into consideration is known as total return. Total return is considered by many to be the most accurate measure of performance.
Here is an example of an income-producing holding and the different ways to consider performance:
1. Income Return
Investor ABC purchases $1,000 worth of Stock X
Stock X distributes a $20 dividend every six months
Income return for one year is 4% ($40 of total dividends divided by purchase price)
2. Total Return
Investor ABC purchases $1,000 worth of Stock Y
Stock Y distributes a $20 dividend every six months
In one year, the price of Stock Y falls to $800
Total return for one year is -16% ($40 dividends minus $200 stock depreciation divided by purchase price)
3. Investor ABC purchases $1,000 worth of Stock Z
Stock Z distributes a $10 dividend every six months
In one year, the price of Stock Z rises to $1,200
Total return for one year is 22%.
The third example above indicates that even though Stock Z produced the least amount of income compared to Stock X and Stock Y, it actually provided the greatest increase in wealth since initial capital increased 20%. If Investor ABC truly required the $40 of annual income, they could supplement the $20 dividend income by simply liquidating an additional $20 worth of Stock Z and still have $1,180 in stock remaining.
At Wealthstream Advisors, we believe that income can be a powerful contributor to a portfolio given a client’s specific need, however investors must also consider appreciation/depreciation.