2007 Report to Clients*

 

GROWTH & INCOME FOR RETIREMENT:

Counterintuitive Observations on Portfolio Design

By

Sam Dreher

(January 2008)

Much common wisdom in the investment community emphasizes growth via equity ownership over income for retirees. Yet an examination of the dramatic growth in the Dow Jones Industrial Averages from 1953 to 2006 reveals that even with a ten-year time horizon, equities can be a dangerous place for retirement capital; counter-intuitively, income(dividends) provides investors with a large, consistent, portion of investment return. This simple concept, well-learned, has important applications in portfolio design and related decisions.

A recently published table of annual Dow Jones Industrial Averages data going back over fifty years presents investors with the opportunity to marvel at a dramatic rise in stock prices (1). As shown in the charts, from the end of 1953 to the end of 2006, the DJIA rose from 280.90 to 12,463.15, an advance surpassing 4,300%. As shown, rising earnings, rising dividends and rising stock prices in this country have presented investors with a wonderful wealth-building opportunity.

Based on the DJIA’s past appreciation of over 4,300%, before dividends, the index is a serious contender as an investment vehicle of choice for future wealth builders. And many investors, now entering retirement, are encouraged by the investment community to maintain a large portion of their investment portfolios in growth investments similar to the DJIA. After all, the logic goes, increased longevity gives today’s retiree a long time horizon with which to enjoy exposure to capital growth.

This article is a preliminary examination of the common wisdom that emphasizes growth over income for retirees, using the results for the DJIA from 1953 to 2006. If we combine the gross return from growth of 4,340% with dividends received (approximately 1,390%), the total return is 5,730% for the 53-year period. Growth accounts for 75.7% of this return, with dividends amounting to 24.3% of the total. On the surface, therefore, growth is more prominent and dominates the final results. Thus, it is a logical step to embrace growth in investment portfolios, including those of retirees with “long time horizons.”

Definitions and Assumptions:

To analyze this precept, it is necessary to agree on what is meant by the term “long time horizon.” On an arbitrary basis, this analysis uses ten years. For example, buying the DJIA at the end of 1953 resulted in capital growth of 172% by the end of 1963. Excluding income (dividends in this case) for the moment, it would seem like a pretty successful investment program for an individual to grow his capital by 172% after being retired for ten years. Making a further assumption that this hypothetical retiree’s spending needs require 5% of his principal every year, then the results for the 1953-1963 period are indeed successful: capital growth is 172%; spending is 50%, and any dividends that come in are gravy.

A corollary to these parameters of success—again, arbitrarily assumed—is that an investment failure might be one in which capital growth was flat or negative ten years after retirement. Given the same spending rate of 50% over ten years, flat to negative growth for the period would result in capital depletion of 50% or more before dividends are taken into account, clearly an unsatisfactory performance for most retirees ten years into retirement. Refining this assumption further, investors might also agree that, given a 50%, ten-year withdrawal rate, capital growth below 25% for the period represents an unsatisfactory result, or investment failure. Without factoring in dividends or using any compounding, growth of only 25% over a ten-year period would leave our hypothetical retiree down 25% after spending needs.

Characteristics of Growth:

Given these admittedly arbitrary definitions of success and failure, it is possible to examine the characteristics of growth and income contained in our data source. As outlined in the table below, average annual growth for the DJIA from 1954 to 2006 was 8.7%, with a rather high standard deviation of 16.3% and median annual appreciation of 11.8%. These figures point to potential variability in the results one might expect over shorter time periods (such as ten years). In fact, the range of growth for the DJIA confirms this suspicion, with a high of 44.0% appreciation in one year versus a decline in value of minus 27.6% for one year.

TABLE: DJIA ANNUAL RETURN CHARACTERISTICS

DJIA Price Growth: 1954-2006

DJIA Dividend Growth: 1954-2006

Dividend Yields: 1953-2006

Annual Average

8.7%

5.7%

3.6%

Standard Deviation

16.3%

8.1%

1.3%

Median

11.8%

5.8%

3.6%

Internal Rate of Return

7.4%

5.4%

N/A

Range:              High

44.4%

33.4%

6.4%

Range:          Low

-27.6%

-8.2%

1.5%

The discrepancy between average price growth and internal rate of return (IRR) is further evidence that appreciation might not be as smooth as the picture of DJIA prices seen in the above chart. Internal rate of return represents the constant annual growth necessary to achieve a given value with a given investment over a given period of time. In this case, $280.90 would grow to $12,463.15 if invested at 7.4% annually from the end of 1953 to the end of 2006. The IRR is the most conservative measure of investment results. Due to volatility in investment returns, IRR can vary substantially from other measures of investment return, such as average and median.

With these characteristics of the DJIA’s price appreciation in mind, one might expect some variability in the results attained by investing retirement capital in the index. This hypothesis can be tested using ten-year rolling investment periods beginning in 1963. (In other words, the results from investing for ten years from the end of 1953 to the end of 1963, the end of 1954 to the end of 1964, etc, without taking dividends into account.)

On average, the figures look good: from growth alone, the capital more than doubles every ten years with an average of 120.7% and a median of 103.0 %.

 

   
Histogram: 10-Yr Growth DJIA (1963-2006)

   

Average = 120.7%    

Std Dev = 103.0%    

Median = 103.0%    

Range = -30.0% to +323.0%  

   

   

1974

1976

   

1978

1970

   

1975

1983

2003

 

1977

1972

1967

2004

 

1981

1966

2005

1993

 

1982

1968

1964

1992

 

1979

1985

1987

1994

1991

1973

1986

2002

2001

1997

1980

2006

1988

1989

2000

1969

1984

1963

1995

1999

1971

1965

1990

1996

1998

-50% to +24.9%

+25% to +99.9%

+100% to +174.9%

+175% to +249.9%

+250% to +324.9%

Using the histogram above for a closer look, however, reveals problems with using growth for reliable investment return. Although, on average, investors would experience over100% growth every ten years, due to variability of returns, retired investors would endure sub par performance of less than 25.0% in eleven of 44 years (1963 to 2006) of rolling ten-year periods (2). Another way to describe these results is that retirees investing in the DJIA, without dividends, for the past 44 ten-year periods would have experienced a failure rate of 25% (eleven divided by forty-four), based on the parameters set forth earlier. As predicted, therefore, the variability of annual returns discussed above can make growth investing a dangerous proposition for retirees. It’s one thing to have a fifty-plus year time horizon for wealth building; it’s quite different—and a problem—to have a loss in retirement after ten years of investing. Although the 4,300-plus percent gain shown in the chart above could be fertile ground for wealth builders, the same territory could be dangerous for retirees.

Characteristics of Income:

Fortunately for investors, there is another component to investment return: income (dividends in this case). Return from dividends takes on a strikingly increased importance when compared to the characteristics of growth described above. As might be expected, DJIA dividend growth was more constant, averaging 5.7% annually for the period with a standard deviation of 8.1%, a median of 5.8% and an IRR of 5.4%. The range of dividend growth was plus 33.4% to minus 8.2%, exhibiting much less volatility than growth by itself.

Parenthetically, using the average dividend yield of 3.6% for the period (also the median yield indicative of low variation over the years) and combining it with the IRR for price appreciation of 7.4%, one can derive an annual stock market return of 11.0%, a figure widely recognized by academics as representing the upper limit of equity returns over long time periods. Of particular note, under this return measure dividends account for 32.7% of the total return.

       
Histogram: Cumulative 10-Yr Div Yields on DJIA  

  (1963-2006)  

1971

       

1969

   Average = 53.4%    

1973

   Std Dev = 14.4%    

2003

   Median = 49.0%    

2001

   Range = 30.4% to 86.0%  

1976

       

1999

       

2002

       

2004

       

1982

       

1968

       

1970

       

1972

1998

 

1987

 

2006

1965

1996

 

1994

 

1975

2000

1997

 

1990

 

2005

1966

1986

 

1988

 

1974

1979

1964

1995

1992

 

1977

1980

1983

1985

1963

1984

1978

1981

1967

1993

1989

1991

30.0% to 39.9%

40.0% to 49.9%

50.0% to 59.9%

60.0% to 69.9%

70.0 to 79.9%

80.0 to 89.9%

As described, dividends represent a larger portion (almost 33%) of total investment return than they appear to on the surface. Also, as shown in the histogram, dividends are very consistent compared to growth. In any of the ten-year investment periods ending from 1963 to 2006, the worst result was plus 30%. In other words, investing in the DJIA at the end of any year since 1953, investors would have earned at least a 30% return on investment in ten years. Looking at the parameters for success and failure set forth above,  therefore, it is interesting that, using dividends without considering growth, the failure rate was zero: there was never a ten-year period of negative return and there was never a period of below 25% cumulative return.

Granted, it is not reasonable to look at dividends (or other types of income) without taking into account the changes that occur to the value of the investment needed to generate the income in the first place. This “change in value” is growth, whether negative or positive, and investment return by definition is a combination of both income and growth. Hopefully, though, this analysis establishes that income has two very important roles to play in the total return process:

  1. Income is a significant portion of the total return, larger than appears on the surface.
  2. Income’s more consistent nature increases its prominence as a component of total return, a quality especially important for retirees.

Conclusion

By its nature, growth depends on a buyer other than one’s self willing to pay more for the same investment. Thus, even if earnings rise, buyers in the future might not pay enough for them to generate any growth (increase in price) for the first owners. And vice versa: lower earnings might receive higher multiples that result in higher prices. Further, not only is it next to impossible to forecast what multiples will be paid in the future, it is also indefinite as to when the prices might be paid. In other words, one cannot predict what another will pay for one’s ownership, nor can she predict when the payment will occur (3).

In contrast to these vagaries of growth, income generated by a reliable source is steady and predictable. Given this characteristic, and in contrast to growth that by itself could be said to have a 25% investment failure rate, it might behoove retired investors to emphasize income when they are designing their portfolios. For instance, given a 5% withdrawal requirement, a retiree with an investment portfolio generating 4% current yield could withstand a certain amount of principal fluctuation, since she would only spend 1% of her principal to satisfy her spending needs. On the other hand, a portfolio yielding only 2% would require the investor to withdraw 3% from principal, perhaps at an inopportune time.

Application:

Charlie Munger (Warren Buffett’s partner) has been quoted as saying that fully understanding an idea can make a large difference in one’s life. While these differences between growth and income, and in particular their relevant characteristics, may be a simple concept, understanding them well should have profound meaning for retired investors and their investment advisers. In application, this understanding may lead to some counterintuitive conclusions and applications that reach outside direct portfolio management. For instance:

  • We all know that investment return does not equal investor return, because the available return faces many sources of attrition. Income taxes are one example. Make no mistake about it, regardless of one’s political view point, the current capital gains treatment for ordinary dividends is a wonderful break for retirees. Under current legislation, this tax break will expire in 2010.
  • Properly managed, companies pay dividends from reliable income sources. Dividends are thereby more important to investors than stock buy-backs, which many times come from extra earnings that are temporary, or worse, from leverage that could diminish the ability to pay dividends.
  • Inflation is another source of investment attrition, since it reduces the spending power of a given stream of income. Reliable dividends that grow with earnings, such as dividends from utility companies and high-grade industrials, help to diminish the effects of inflation.
  • Investment fees are another source of attrition. Direct investments, such as bonds versus a bond fund, can eliminate a whole layer of investment management fees.
  • A ladder of individual bonds that enables investors to reinvest principal maturities at higher rates of return can mitigate the effects of inflation and also eliminate one layer of investment fees.
  • Financial engineering in the form of exchange-traded mutual funds (ETF’s) and other low-cost investment indices now make possible an infinite number of portfolio designs. Investors and their advisers should be able to assemble investment portfolios with the right amounts of growth and income based on individual circumstances. Using ETF’s, both income and growth can be diversified, efficiently, by industry, capitalization, investment style and country and be denominated in any number of currencies.
  • Full understanding of income in the investment process provides insight into Social Security benefits: when they should be initiated and how they should be integrated into the investment portfolio and spending budget.
  • Full understanding of income also lends insight into considering immediate annuities and similar income streams.
  • Of at least equal importance, a full understanding of income and its characteristics in the investment process has important implications for retaining investment counsel. If one’s adviser, broker, consultant or whatever she is called is not talking about investment selection in terms that encompass these issues, then perhaps it is time to look for assistance elsewhere. In an investment environment where pure growth might have a 25% chance of failure, it’s not enough for the standard “…your time horizon is long, you need growth, here it is, who’s next…” solution. Integrating growth and income into the investment/ budget is a complex process that needs to take into consideration all of the items listed above and more.

Qualifications:

This article makes broad implications from limited sources. For example, a study of any number of alternative stock indices could yield different results. One might examine the S&P 500, S&P Mid-Cap 400, S&P Small-Cap 600, Russell 1,000, 2,000 or 3,000 to name a few. The trajectories of especially the smaller cap indices appear to have differed from those of their larger relatives. Nevertheless, it seems stunning, and counterintuitive, that a stock market rising over 4,300% during the past 50 years can present so much danger to those, such as retirees, seeking to participate using reasonably long time horizons. Given today’s technologically endowed investment landscape that allows investors to inexpensively tailor their investments to meet their individual circumstances, the idea of arranging, and rearranging, the balance between income and growth seems worthy of consideration.

 

(1) Barron’s, editions in 2006 and 2007.

(2) In five of the ten-year periods, returns were actually negative.

(3) In fact, and as a surprise, it was difficult to find any meaningful correlation between earnings growth, price earnings ratios and future levels of stock prices, at least using this data source.

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