Income or Assets?

Which financial benchmarks are you most focused on? And, how often are you evaluating the overall value of your portfolio compared to the income that it generates? In other words, what’s more important for achieving your financial goals: your income or your assets?

This post will describe why and how income benchmarks will help you evaluate your portfolio.

Retirement Goal

“Retirement” is a financial goal most investors have. So, let’s describe common methods of retirement planning to illustrate which financial benchmarks are the most commonly used to determine retirement goals (hint, they are typically asset based benchmarks).

At first blush, it would seem like measuring the income from a portfolio would be important for reaching a retirement goal. This is because the income from a portfolio is what a retiree will use to fund their lifestyle in retirement.

But counterintuitively, most financial planners will determine how much assets investors will need to reach their retirement income goals, and then work backwards to determine how much they need to save in order to reach that asset level.

If we know your age, the size of your current portfolio, how much you can save between now and retirement, and your desired level of income in retirement, then we can determine the age at which you might be able to retire. Or, if you choose a retirement age, we can determine how much you’ll need to save between now and then.

The common result of conventional retirement plans is a target level of assets your portfolio will need to achieve for you to retire. Is this the best way to benchmark retirement goals? Should we be only evaluating the assets you might need? Or, should we also consider the income your portfolio generates?

Wealthy Investors

Looked at another way, most wealthy investors have already “retired”. In other words, wealthy investors could “retire” if they wanted to because their level of wealth exceeds their ability (or desire) to spend down their capital to support their lifestyle.

Instead of a retirement financial goal, most wealthy investors have the goal of generating enough income from their portfolio to support their lifestyle. Generating income and protecting capital are usually the first financial goals of wealthy investors.

To benchmark your wealth, determine how much income you require to support your financial goals (lifestyle, family, philanthropy) and then compare this amount to the yield on your portfolio.

For example, if a typical 60/40 portfolio of stocks/bonds yields 3.5%, and you require $240,000 per year of income, then you’ll need at almost $7 million dollars in such a portfolio to achieve your income goal (i.e. 240k / 0.035) without encroaching on your capital. The lower your income requirement, the easier it will for you to achieve financial freedom.

Income Goals

For both retirees and wealthy investors, the number one financial goal is usually the same: “generate enough income from my portfolio to sustain my lifestyle”. Success can be measured by an income level, not necessarily an asset level. The more sustainable income a portfolio can generate, the easier it is to reach this lifestyle goal.

It might sound obvious, but when an investor has an income requirement, their portfolio should generate this income. Relying on an investment to gain in value to provide enough capital to satisfy an investor’s income requirement is a lot riskier. This is where the financial industry often leads investors in the wrong direction (and adds too much risk).

When making retirement projections, most financial advisors will assume you can spend down your capital in retirement. However, most investors would prefer to simply use the income from their portfolio without touching their capital at all. Protecting capital is certainly a preference of most wealthy investors too. The desire to protect capital is something most wealthy investors prefer. This includes both entrepreneurs and inheritors.

So, if Investors overwhelmingly want to preserve their capital and live off the income that their capital generates, rather than encroach on their endowment. Shouldn’t we be more closely evaluating the income our investments generate?

Conventional financial planning still tells us to focus on the assets we need to save for retirement instead of highlighting the income that those assets will generate.

With this conventional wisdom in mind, why does the investment industry focus so much on asset benchmarks instead of income benchmarks? What other approaches might investors take?

Whose Interest?

Part of the explanation about why the financial services industry focuses on asset level goals so much is that it serves their interest best, at the expense of investors.

After-all, investment managers are typically paid by a percentage of the value in your account. If the absolute value of your investment assets rises, then the company providing you with investment advice makes more profit. So, it makes sense how the investment industry makes portfolio value the key benchmark to evaluate.

But let’s remember, the value of your portfolio is not determined by the company providing you with investment advice. The value of your portfolio is determined by the performance of markets and the overall economy, which is out of the control of any single investment company.

Have you ever seen an investment advisor who charges a fee based on the income your portfolio generates? Probably not, since this type of fee arrangement rarely exists. A fee for income arrangement might not serve the interest of the investment company earning fees from your account.

Paying for income performance will force your advisor to focus on high-quality blue-chip investments that pay healthy dividends. Not a very profitable niche when index funds already exist. Better for the investment industry to pitch exciting ideas in complex packages.

Why focus on asset value first? Because it serves the interest of the financial industry.

Emotional Roller Coaster

There is another downside to focusing on the asset level of your portfolio when benchmarking your results.

When the key benchmark used to evaluate whether you reach your financial goals is the current market value of your investments, it sets you up to ride an emotional roller coaster. Since, the current market value of your portfolio will continuously rise and fall as prices change.

Most investors struggle with emotional bias. We let our emotions guide our investment decisions. And doing so has major negative consequences to our returns. We end up buying high and selling low. Our emotions cloud our financial decisions and cause us to under perform the market.

So, by using market value as the key benchmark when evaluating our portfolio, we open the door to our emotions. Sometimes prices rise, sometimes prices fall. The future is out of our direct control. Watching the value of our life savings or inheritance rise and fall with the headlines is tough to do.

Most investors “feel” it.

But if we pay less attention to the value of our assets on any given day and if we focus on the income generated from our portfolio instead, we will gain a much higher degree of control and confidence.

Shifting Benchmarks

The investment industry wants to make money from our capital, and our emotions play a large role in our investing decisions. If we only pay attention to the market value of our assets instead of the income generated by them, the yardstick used to evaluate our success will keep shifting too.

The value of money today will be different than the value of money in the future. This means that in the future, the amount of capital you may need to generate a certain level of income will be different also.

Additionally, the purchasing power of your capital and desired level of income will also be different. But, when we consider whether income or assets might be a better benchmark, maybe we should pay more attention to the income generated from our investments? The income generated will be a lot less volatile.

The market value of your investments is likely a lot more volatile than the income it generates.

An investment portfolio of dividend paying blue chip stocks provides a steady stream of income. So long as the economy is growing, and general price levels are rising, there is an almost certain chance the dividends from your blue-chip stocks will also rise over time.

The pace of dividends is steady compared to the rise and fall of asset values.

For this reason, it helps to evaluate your portfolio using more income-based benchmarks. The psychology of receiving income is much more positive for the investor than the market value of an underlying portfolio of investments on any given day.

Income is accretive. It can only go up. Whereas the market value of your portfolio can both rise and fall. Negative income does not exist, the opposite of income are expenses. And, expenses are under our complete control.

A portfolio of income producing investments will give investors much greater peace of mind. Our risk aversion psychology might also make it easier for investors with lower risk preferences to accept greater investment risk when those investments provide an income stream.

Pension Funds & Insurance Companies

The psychology of investing might partly explain why pension funds are so appealing to savers.

Figuratively, pension funds put your money into a black box, and then provide plan members with periodic reports about when they can retire and what level of income they can expect to receive in the future. In this way, pension funds may reduce a plan member’s emotional influence on their capital. Pensioners can’t “touch” it. They don’t see the value of their individual pension rise and fall with its market value.

Something similar happens when you approach an insurance advisor for retirement advice. An annuity is like a pension fund in the way your capital is pooled with other investors. You only receive the income from this pool, not necessarily the capital. So, it doesn’t necessarily matter how the annuity pool portfolio performs (so long as its solvent).

Maybe other investors should take lessons from pension funds and annuities?

Protect your capital, and treat is like an endowment.

When I was started out on Bay Street, I worked on the trading desk of a large bank. One of our clients would rapidly buy and sell futures contracts for thrills like a gambler. He was a wealthy investor who inherited his wealth from his father. This client seemed like a terrible investor. He’d trade futures contracts on a whim and often lose. But he never ran out of capital. Why?

His father was a legendary investor and gave his son some valuable advice. The father gave his son $100 million dollars of capital on his 18^th birthday. In many ways, this ruined his son’s life. But financially, he told his son that he could only spend the income from his endowment, and never dip into his capital.

To generate income, the son dutifully invested in a portfolio of mostly bonds and some blue-chip stocks. Even with a yield of only a few percentage points on his capital, the son could still generate a few million dollars of income each year. With this income, the son blew his brains out in a variety of ways including bad investments and lots of material luxuries. Not only could he live to see another financial day, but his capital endowment remained intact.

The lesson I took early in my career from this wealthy inheritor (aside from how bad it is to give your kids money without much preparation) was to protect a capital endowment carefully and find ways to make it consistently earn income. This income provides flexibility and financial peace of mind. This income provides freedom to investors to make other investments. Whether it be angel investing or buying a new car.

So long as an investor only uses the income from their portfolio, and never dips into the capital, they will never go broke.

Once an investor takes the position that their capital is an endowment that they’ll never encroach upon, it creates a type of discipline. Such an investing style forces us to consider investments that generate profit and income, rather than growth. Instead of being distracted by the latest fad from someone giving tips over lunch (or at a cocktail party), we might think more about generating income from our investments instead.

Make it Simple

Investing can be a lot less complicated than the financial services industry has led most of us to believe.

Mountains of data prove that a simple investing strategy using low cost index funds performs better than most active investment managers. Simple DIY “buy-and-hold” investment strategies have also served generations of investors quite well without the need to pay for stock picking advice.

Simply picking one or two broad based index funds and holding them for the long-run will serve any investor well. Canadian investors can use the S&P/TSX 60 Index and/or the S&P 500 Index for growth and maybe an index tracking bonds or REITs for a counterweight.

DIY investors could easily choose some basic criteria to replicate a similar yielding portfolio to the indexes mentioned above. Such screening criteria might include only investing in stocks that pay dividends. And/or only investing in stocks that pay dividends and are included in the indexes mentioned above.

Using an investment advisor is also a good strategy too. Just make it clear that you wish to generate income from your portfolio, and this will be the benchmark that you will use to evaluate their performance. Don’t settle for advisors who are trying to predict the future.

Evaluating Income

The ups and downs of the stock market should have little impact on the income-based investor. If you’re investing in high quality investments that are profitable and which pay dividends or interest, you should be generating an income during any economic environment.

Like Warren Buffett, you should welcome a downturn in the markets as it provides you with a greater opportunity to acquire more income at lower prices.

When you evaluate your investment portfolio. Ensure that your advisors provide you with reports about the level of income your portfolio is generating. Your income should always be rising, never falling.

To make sure this is happening, never sell your investments based on an expectation the markets might fall. Never liquidate your profitable investments. If you think there are clouds on the economic horizon, don’t sell your current investments, simply let your cash pile up. This is what legendary investors like Warren Buffett do. They never sell.

How Might a Family Office Help?

Many “family offices” are simply investment advisors in disguise. Investors should beware of this red herring. The typical multi-family office serves several clients by providing investment advisory services first, and then maybe a suite of ancillary administrative services on the side (to generate excitement from prospective clients or to cloud their practice in an air of mystique).

Frankly, most of these so-called family offices would be happy to provide only investment advice. Since, the other services they provide are not as profitable. For proof of this, simply consider a breakdown of the fees most wealthy investors pay.

The overwhelming amount of fees wealthy investors pay go towards investment advice. Second place isn’t even close. Consider an investor with $100 million in their portfolio paying 0.25% per year of investment management fees. This comes out to $250,000 per year of investment management fees compared to maybe $20,000 to $50,000 for tax/accounting services depending on the complexity of their holdings.

Shockingly, the fees wealthy investors pay for investment management are often much higher than 0.25% too. A typical 2%/20% fund structure results in a base annual fee of $2 million on the same size portfolio. This means a typical high net worth investor might be paying 100 times more for investment advice than for tax advice. This is a bad deal for investors and a good deal for investment advisors.

What makes a real family office is one that does not charge for investment advice. An honest family office is one that is working in the best interest of the family, with compensation based on delivering services, not investment returns.

The truth is that good investment returns are not difficult to achieve. Simply use index funds. Wealthy investors don’t need to search for higher rates of returns when low cost transparent index funds can already meet their needs.

If you have values that prevent you from investing in broad based index funds or if ESG indexes are not your cup of tea, then a buy-and-hold portfolio of blue-chip dividend paying stocks that meet your investment criteria and they will work just as well (maybe better).

Instead of focusing on investment returns, a good family office should be working towards improving the financial life of your family. This includes doing things like working to reduce costs, simplifying the financial life of your family, documenting important details, and generating reports that keep your advisors accountable. In this process, a good family office should be refocusing the conversations about investment performance towards generating consistent results instead of chasing returns.

An endowment approach to investing, as described here can be very simple to implement. Benchmark your portfolio by the income that it generates. This doesn’t require an investment advisor in a high rent office downtown.

A good portfolio requires clear objectives, a consistent strategy, emotional fortitude, and patience.