Certified Financial Fiduciary and Author
What Does It Mean to Have a Portfolio Focused on Total Return?

What Does It Mean to Have a Portfolio Focused on Total Return?

Saving for retirement can be extremely stressful—you need to ensure you can maintain a comfortable lifestyle without running out of money, but you don’t know exactly how long that will be.

The best strategy for avoiding bankruptcy in retirement is to save as much as possible, which generally involves investing money. Investing money in riskier assets, like stocks, can help drive growth, but it also raises the possibility of losing money. When saving for retirement, you need to walk the line between growth and capital preservation.

Low-risk accounts are unlikely to grow enough to provide safety, but overly risky approaches can prove just as problematic. Figuring out how to achieve this balance is difficult, and the approaches to it have changed dramatically in the past century.

Gradually Focusing on Total Return

Not long ago, the primary focus of retirement investing was income. People would invest in dividend stocks, convertible bonds, and preferred shares. All of these assets have relatively high returns. Many retirees wanted to live off the income from these kinds of investments so that they would not have to touch the principal. Financial advisors often pointed people toward investments with the largest yields. While this strategy makes sense on the surface, it can inhibit the overall returns of a portfolio while exposing individuals to much more risk than is necessary. Also, when this strategy was in vogue, dividends and interest were significantly higher and life expectancies were shorter.

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Modern financial theory removes the focus from individual securities and instead puts it on overall asset allocation and portfolio construction. As a result, the emphasis is not on income but rather total return. The entire portfolio is constructed in a way that still provides distributions to support individuals in retirement, but these payments can come from different parts of the portfolio to provide greater protection for that income. Various investments are chosen for their growth potential rather than their ability to provide income to the investor.

A Framework for Approaching Total Return Investing

Often, total return investing involves making moves that seem counterintuitive, so many individual investors do not follow modern financial theory—even though it has been largely accepted that income-driven investment is inappropriate.

For example, consider an investment with a 4 percent dividend and an expected growth rate of 2 percent and a second with an 8 percent return but no dividend. Most people would opt for the dividend-producing investment, but it is safer to choose the second option. The second option will grow faster and ultimately be worth more even though it is not paying dividends as income. With a total-return approach, the portfolio can provide cash distributions dynamically depending on the situation without trading growth potential for income.

As a general guideline, many total-return portfolios allocate about 40 percent of assets to high-quality, short-term bonds while the remainder goes to diversified and global equities. For ideal diversification, you should have about 10 to 12 asset classes among these equities. With this distribution, money can be generated in a variety of ways. For example, in a down market, you should leave your equities alone and allow them to recover. At this time, the bonds could support distributions for up to 10 years before any equities would need to be liquidated. When the market is up, you can sell shares to provide income, with the surplus being reinvested in the portfolio.

The Importance of Rebalancing with a Total-Return Approach

When you have a total-return portfolio, you will need to rebalance it periodically. Rebalancing forces you to sell high and buy low among different asset classes.

Risk-averse individuals often choose not to rebalance their stocks and bonds because the class that has outgrown its allocation is performing well. The 60 percent allocation mentioned above will quickly grow when the market is up, while the bonds may outgrow their allocation when the market is down. Keeping assets that are performing high seems to make the most sense, but maintaining a balance provides the highest level of protection against loss as the market fluctuates. Selling off high-performing assets and buying ones that are currently down provides the greatest growth over time.

Sometimes, investors choose not to rebalance when the market is down because they feel like their safe assets are keeping them above water. Choosing not to rebalance during a down market can protect future distributions if the equity market stays down for an extended period. However, this protection does come with an opportunity cost when the market recovers. The growth of the portfolio will not be as high as it could have been. Thus, investors need to think about this opportunity cost and balance it against their need for security during a down market.