Worst average return on 60% equity portfolio over the next 20 years?

coyrls

In "Beyond the 4% Rule" by Abraham Okusanya, he has a section titled: "Natural yield: a totally bonkers retirement income strategy". The book is a bit simplistic but he makes a convincing case that "a natural yield approach is a bonkers retirement income strategy for virtually all but very wealthy retirees, who have other sources of steady income to rely on"

Thrugelmir

masonic wrote: »

In a major recession, company earnings will fall. That will affect their share price most significantly, but it will also affect their dividend.

Companies don't just suffer in a recession. They go bust, get taken over, their products get superceded, lose major customers, get their costings wrong, suffer a natural diaster etc etc. Shares are not an ATM.

Huge amount of complacency exists in these benign times.

chockydavid1983

Does that mean accumulation and draw down pots can be similar in terms of allocation (albeit probably reducing equity % as you go on in time) where in accumulation your emergency fund covers 3-6 months expenses and in drawdown your emergency fund covers 2-3 years poor investment returns?

coyrls

[FONT=&quot]Sorry tables are messed up in the cut and paste below. You can read on FT site if you have a login.
[/FONT]
[FONT=&quot]
[/FONT]
[FONT=&quot]Financial Times[/FONT]
[FONT=&quot] [FONT=&quot]Busting the Myths of Investment: Who needs income?[/FONT]
[FONT=&quot]Terry Smith[/FONT]
[FONT=&quot]3rd October 2018[/FONT][/FONT][FONT=&quot]

There seems to be something so alluring about dividend income that it often seems to lead investors to abandon common sense or be encouraged to do so by the investment industry.

For example, how many times have you heard it said that the majority of returns from investment in equities comes from reinvestment of the dividends? This assertion is usually accompanied by charts which show the difference in returns from an index with the dividends paid out versus one where the dividends are reinvested. Unsurprisingly, the latter has a significantly higher return. But this is not the same as demonstrating that the majority of returns come from reinvested dividends. In fact, they come from retained profits.

Take the example of an average S&P 500 company. Currently it has a payout ratio of 52 per cent — in other words half its profits are distributed as dividends — a return on equity net of tax of 15 per cent and its shares trade on a price to book (market value divided by book value) of 3.5 times.

So, which generates more value for shareholders, reinvestment of the dividend paid out, or the reinvestment of profits by the company?

The first handicap of reinvested dividends is that dividends are taxable in the hands of most shareholders. The exact amount of tax payable will depend upon where the shareholder is resident and which tax band they are in. If you are in the UK and a higher-rate taxpayer, dividend income will be taxed at 32.5 per cent, so you will only be left with 67.5 cents out of every dollar of dividend to reinvest. (I am using US dollars as I chose the S&P Index for the example, but the principles are the same for the FTSE 100 and sterling.)

Handicap number two is that you reinvest at the market price for the shares which, given the price to book is 3.5x, means that you will get to own just 28.5 cents (100 ÷ 3.5) of the company’s capital for every $1 you reinvest. For every $1 of dividend paid out you get 67.5 cents after tax, which buys you just 19 cents of the company’s capital (67.5 ÷ 3.5).

That doesn’t sound like much of a bargain. In contrast, every $1 of retained income which also belongs to you as a shareholder suffers no additional tax and is reinvested in the company’s capital at book value, so you get 100 cents of capital for every $1 retained.

As if that is not enough of a reason to prefer retained earnings to dividends, each $1 which is retained on your behalf is turned into $3.50 of market value because the company’s shares trade on 3.5x book.

This is the arithmetic of compounding and it is what equity investors should seek to capture, as those in Warren Buffett’s Berkshire Hathaway have done since it has not paid a dividend since Mr Buffett took control in 1965.





The chart illustrates this. It shows the performance of Berkshire Hathaway’s stock since 1977 as it actually occurred (the earliest date for which data is available for this analysis) — with all the earnings reinvested. Against this we have compared what would have happened if instead half the earnings were paid out and then reinvested after tax (estimated at 30 per cent) at market price.

The effect on investors’ returns is startling, as the table shows.


ANNUAL COMPOUND RETURN ON BERKSHIRE HATHAWAY SHARES[/FONT]
[FONT=&quot]Berkshire reinvests all net income [/FONT]
[FONT=&quot]Berkshire pays 50% of net income as dividend[/FONT]
[FONT=&quot]19.0% [/FONT]
[FONT=&quot]14.0%[/FONT]
[FONT=&quot]Source: Fundsmith LLP


This is a feature of equities which no other asset class possesses. A portion of the returns that companies generate are retained and automatically reinvested on your behalf. This creates more value than you can ever capture by reinvesting dividends — except, of course, when the reinvestment is done badly with management investing when returns are inadequate.

It is not a feature of bonds or property assets. Investors receive interest or rent from these investments, but they are not reinvested for you. This advantage of equities is magnified if instead of investing in an average company you invest in a company with a higher than average rate of return on capital.

Given this, it seems remarkable that income funds outsell all other types of funds by some margin. Because of this marketing phenomenon, funds use income in their name and seek to qualify for the Investment Association’s equity income sector.

Amazingly, they can claim membership if they have a yield which exceeds the yield on the FTSE All-Share index by any amount, no matter how small, over a three- year rolling period, which is a rather low bar. In the event that a fund fails this test and is excluded from the sector, it is not required to remove the term “income” from its name. And the investment industry wonders why it gets a bad name.

But why do people want income from equities in the first place? The need to get spending money from your investments once you’re retired is obvious. But why does it have to come from dividends? Surely the right approach is to invest for the maximum total return you can achieve and then redeem whatever units you have to provide for your spending needs.

The benefit of this alternative approach is evident if you compare the performance of the MSCI World Index with the High Dividend Yield (HDY) subset of the same index (see below).


INDEX PERFORMANCE (%)[/FONT]
[FONT=&quot]Term[/FONT]
[FONT=&quot]MSCI World HDY [/FONT]
[FONT=&quot]MSCI World[/FONT]
[FONT=&quot]1 year [/FONT]
[FONT=&quot]7.40 [/FONT]
[FONT=&quot]13.71[/FONT]
[FONT=&quot]3 year [/FONT]
[FONT=&quot]10.67 [/FONT]
[FONT=&quot]12.56[/FONT]
[FONT=&quot]5 year[/FONT]
[FONT=&quot]8.35 [/FONT]
[FONT=&quot]10.84[/FONT]
[FONT=&quot]10 year[/FONT]
[FONT=&quot]7.02 [/FONT]
[FONT=&quot]7.74[/FONT]
[FONT=&quot]Source: Fundsmith LLP


The index outperformed the high-yield stocks, and this comparison understates the performance advantage of avoiding the high-yield stocks since they are still included in the MSCI World Index. Investors could invest in an index tracker, sell enough units to match the HDY yield and be left with more capital than they would have if they had bought the High Yield Index. Yet most investors seem to regard this idea of redeeming part of the capital sum to provide income as the road to perdition.

[FONT=&quot]Terry Smith is the chief executive and chief investment officer of Fundsmith LLP. The views expressed are personal.[/FONT][/FONT]

bostonerimus

masonic wrote: »

As bostonerimus says, it's not really feasible to rely solely on dividends.

Just a bit of a correction; I was describing where you can generate income, whether or not you need to tap all those sources depends on how much income you need. It's perfectly possible to rely purely on natural yield if you pot is big and you income needs are modest.

TBC15

Well,Terry has put that one to bed I think.

londoninvestor

chockydavid1983 wrote: »

Does that mean accumulation and draw down pots can be similar in terms of allocation (albeit probably reducing equity % as you go on in time) where in accumulation your emergency fund covers 3-6 months expenses and in drawdown your emergency fund covers 2-3 years poor investment returns?

I found this a very useful article (posted a variant of it on a different thread last week, but that one was paywalled and this isn't).

Essentially this advocates:

• Determine your asset allocation percentages
• Continue regularly rebalancing - when you need to sell to generate cash, you don't so much decide "am I going to sell equities or not?" - you just rebalance so that your assets after taking the cash are in line with your target percentages.
• And then there is no need for a separate "cash bucket". It isn't needed for its intended purpose of mitigating equity risk, because that purpose comes from the X% you've allocated to non-equity assets.

masonic

bostonerimus wrote: »

Just a bit of a correction; I was describing where you can generate income, whether or not you need to tap all those sources depends on how much income you need. It's perfectly possible to rely purely on natural yield if you pot is big and you income needs are modest.

Yes, I should have qualified that as being in the context of the 3.5% safe withdrawal rate mentioned by the OP earlier in the thread, suggesting a portfolio of ~30 x annual spending. Getting all of that consistently from natural yield with a sensible asset allocation would prove challenging, although I'm aware strategies involving a basket of 'dividend hero' investment trusts have been put forward.

londoninvestor

Also, relying on "natural yield" may not be optimal for tax. It's a shame to pay income tax on your dividends while letting your CGT allowance go unused.

Thrugelmir

coyrls wrote: »

This is the arithmetic of compounding and it is what equity investors should seek to capture, as those in Warren Buffett’s Berkshire Hathaway have done since it has not paid a dividend since Mr Buffett took control in 1965.

BH reinvests dividends it receives back into further investments. Still amounts to compounding.