Investing is a deeply personal journey, shaped by each individual’s financial goals and risk tolerance. In search of financial benefits, many investors are drawn to high-income strategies for immediate cash flow. However, this focus may not be optimal for long-term growth. An income portfolio, rich in bonds and dividend-yielding stocks, offers a consistent cash flow that is appreciated by retirees and those seeking income stability. However, for investors aiming to grow assets, having a balanced allocation of stocks, bonds and alternative assets, including a good amount of growth-oriented assets is important. In this section, we explore the benefits of a balanced income and allocation strategy and the optimal income levels for sustainable long-term withdrawal rates for investors.
Understand the income portfolio
Income portfolios, traditionally bonds with dividend-yielding stocks, are designed to deliver steady cash flow to investors. Its popularity is undeniable among those in need of income. However, they often miss a balanced portfolio that combines income generation with growth potential. Without substantial growth, the income portfolio struggles to beat inflation and maintain purchasing power. Historical data since 2009 shows that a balanced 55/35/5/5 equity / bond / cash / gold (Fig.1) handily outperformed the income portfolio from a total return perspective, highlighting the importance of including growth assets in the investment mix to Capitalize market upswings and compound wealth over time.
Fig. 1 Total return button for long-term wealth accumulation; for Income Strategies, reinvesting income is mandatory. No reinvesting income will result in total return in the long-term
Cumulative return of total return and price return of diversified income allocation* vs total return of balanced allocation** (May 2008 to May 2024)
* Income allocation is proxied by 40% global bonds, 20% EM bonds and 40% dividend stocks
** Proxied balanced allocation 55% Global Equity, 35% Global Bonds, 5% Gold, 5% Cash
Photo credit: Source: Standard Chartered Chief Investment Office
The hidden cost of not reinvesting income
An often overlooked aspect of income investing is the long-term consequences of not reinvesting. While income portfolios provide regular cash flow, they can suffer in terms of compound growth if dividends and interest are regularly withdrawn rather than reinvested. This factor can significantly reduce a portfolio’s growth trajectory over time. While the income portfolio meets immediate financial needs, investors must consider the opportunity cost of eliminating the powerful compounding effect, which is central to long-term wealth accumulation.
Total return: The key measure of success
Total return, which includes interest, dividends, and capital, is an important measure of financial success. Just focusing on income can be misleading because it doesn’t take into account potential losses in asset value. Thus, having a holistic view of portfolio performance, considering both income and growth when evaluating success is key.
This concept of total return is not only important for investment performance but also plays an important role in retirement planning. As investors approach retirement, the focus often shifts from accumulation to wealth preservation and distribution. In this phase, understanding the interaction between total return and withdrawal strategy becomes important.
Fig. 2 Balance and equity Investors have a greater chance of success with a withdrawal rate below 4%
Success rate ** simulated portfolios with different withdrawal rates
Success rate: the proportion of simulated portfolios with positive values ​​after the 30-year retirement period since 1871
* Balanced allocation showing 55% US Equity, 35% US Bonds, 5% Gold, 5% Cash
Photo credit: Source: Standard Chartered Chief Investment Office
The 4% Rule: A Guide to Steady Withdrawals
A balanced portfolio provides a solid foundation for sustainable withdrawals. The ‘4% rule’ is a time-tested principle that offers a benchmark for sustainable withdrawals. This is based on the premise that investors can withdraw 4% of their portfolio in the first year of retirement, and then adjust the amount for inflation every year, without facing a significant risk of reducing their pension fund over 30 years. time.
Fig. 3 Withdrawal rates of more than 6% can be dangerous because of the potential inflation risk and if there is a longer than expected retirement period.
* Balanced portfolio value at different withdrawal rates over a 30-year retirement from 1871; start with USD100,000
* Balanced allocation showing 55% US Equity, 35% US Bonds, 5% Gold, 5% Cash
Photo credit: Source: Standard Chartered Chief Investment Office
At higher withdrawal rates, the risk of prematurely reducing the portfolio increases significantly. For example, if retirees withdraw at a higher rate, say 8%, then they may have a more comfortable standard of living. However, this comfort can be short-lived if the market experiences a downturn, or if inflation rises unexpectedly. A higher withdrawal rate will accelerate the reduction of the portfolio’s principal, which may result in the portfolio’s condition being depleted earlier than expected. Additionally, higher withdrawal rates also limit portfolio growth potential. Since a large part of assets are used for current expenses, less to invest and compound over time. This can be particularly detrimental in the early years, as the effects of compounding are strongest in the long term.
Create a balance in our stock bond mix
A portfolio allocated entirely to stocks or bonds is rarely optimal. Figure 2 suggests a higher allocation to equities typically provides better growth, while a 100% bond portfolio is the worst because it yields lower returns. However, a 100% equity portfolio carries higher risk due to greater volatility. Given the following two options for investors: 1) a 90% chance to live for another 30 years, but the chance to run out of money after 7 years, and 2) a 90% chance to live for 30 years, but a chance to run. out of money after 25 years, the latter is clearly better. Stocks increase the chances of success here but are subject to return and market cycle risks, while bonds will reduce the chance of a portfolio failing too early. Therefore, balance is key.
Fig. 4 Historically, a balanced strategy is better at protecting against premature failure and helping to preserve long-term value.
The number of months before the first dip into negative values ​​by the simulated portfolio
* Balanced allocation showing 55% US Equity, 35% US Bonds, 5% Gold, 5% Cash
Photo credit: Source: Standard Chartered Chief Investment Office
Navigate market volatility with a balanced portfolio
Achieving financial success involves more than just choosing between income and growth. This requires a judicious combination, which suits the needs and goals of the individual. Income portfolios have benefits, especially for retirees who value predictable cash flow. For those without immediate income needs and a broad investment horizon, a balanced portfolio, including a judicious mix of income and growth assets, is essential to charting the path to long-term wealth accumulation.
Standard Chartered has released its H2 2024 Global Market Outlook. This report combines in-depth research to highlight investment opportunities that investors can pursue over the next 6 months. Get it here: https://bit.ly/3WGLeSj.
Paul Njoki is Head of Affluent Banking & Wealth Management, Kenya & East Africa, Standard Chartered.
