My July column at Physician’s Money Digest (Now MDMag.com) was all about income investing vs total return investing. If you have no idea what I’m talking about, read this column. If your plan is to only spend the interest in retirement, then definitely read this column. For decades, there has been a grand debate afoot in the investing world between “total return” and “income” investors. The truly educated don’t worry about it much because they realize there isn’t a lot to it. Your goal should be to avoid an extremist or absolutist position on the matter.

Income Investing

The basic idea behind income investing is that you only spend the income from your investments. Seems like a great idea, right? It’s easy to know when you have enough to retire—when the income from your investments replaces the income from your job (or at least your living expenses). Plus, you know you’ll never run out of money if you’re only spending the income.

Unfortunately, if you become an extremist in this camp, you may get burned by several issues. There are really 4 ways that income investors get it wrong when compared to a “total return” investor.

1. Income investors are likely to underspend

Safe withdrawal rate studies, such as the Trinity Study, have demonstrated it is quite safe (although not perfectly safe) for you to spend about 4% of a traditional portfolio each year and expect your portfolio to keep up with inflation throughout a 30-year retirement.

However, these days most traditional investments have a yield much less than 4%. The Vanguard Total Stock Market Fund yields just 1.8% and the Total Bond Market Fund is only slightly higher at 2.1%. CDs, “high-yield” savings accounts, short-term bond funds and most muni and Treasury bond funds are even worse. Even value stocks and REITs have yields much less than that.

If you’re only going to be spending the yield on these investments, you’re going to be spending much less than 4% per year. That means you will need to do one of 3 things: have a higher savings rate, work longer, or spend less in retirement. Since you are spending less, you are also likely to leave a lot more money behind at death.

In short, you’ll spend less than you could have if you were willing to spend some principal.

2. Income investors may not hold the best portfolio
An income investor is far more likely than a total return investor to chase yield, since every little bit of extra yield increases his or her lifestyle. However, there are many investments with a high yield whose total return may not be what you would hope. The classic example is junk bonds, and the junkiest of junk bonds these days are peer-to-peer loans.A portfolio of peer-to-peer loans may yield 20%, while only having a total return of 10% due to a high rate of default. If you’re spending 20%, that portfolio isn’t going to last long. That doesn’t mean there isn’t room for higher yielding investments in your portfolio, but you want to make sure you are holding a diversified portfolio with excellent long-term, risk-adjusted returns. Such a portfolio almost surely will include some assets that have a low-yield.

Never forget that a yield of 8% is not the same as a total return of 8%. While it feels good to have an 8% dividend in hand, if the investment actually lost 25% in value, you’re not making much progress financially.

Investment real estate is a particularly attractive asset class for income investors because a significant portion of the return comes from income, often 5% to 7% of a 7% to 10% return. This yield is much higher than anything available in the “paper market” outside of low-quality bonds.

While income property can form a significant portion of your portfolio, a portfolio of 100% real estate doesn’t pass the sniff test when it comes to diversification. In addition, real estate possesses significant downsides as an asset class including significant maintenance and transaction costs, aspects of a second job, and an inefficient market requiring expertise and experience to get solid returns.

3. Income investors may pay too much in taxes
As a general rule, income tends not to be very tax efficient. There are exceptions, of course, as muni bonds are usually federal, and sometimes state, income tax free and some of the income from real estate can be shielded by depreciation, especially early on in the life of a property.Bond dividends, REIT dividends, and CD interest is taxed at your regular marginal tax rates instead of the lower dividend and capital gains rates available with stocks. To make matters worse, you have to pay those taxes even if you didn’t really want to spend that income yet. There is no way to defer the income until you actually want it in the future.

However, a total return investor can often “declare his own dividend” by selling some of his investment—for instance, a few shares of stock. The tax bill on that money (which spends just as well as CD interest) may be very low when you consider the ability to sell high-basis shares, harvest tax losses, and take advantage of the lower long-term capital gains rates, especially in the lower brackets.

4. Income investors may get burned by inflation
Higher yielding investments, such as CDs and bonds, tend not to keep up with inflation nearly as well as traditional lower yielding investments such as stocks.

If you focus too much just on income, you may forget that your real opponent in the investing game is your personal rate of inflation. If your income is steady, or only increasing slowly, and your expenses are increasing at a moderate rate, it won’t take long before you will be faced with an unsavory choice: cut your lifestyle or sell your investments.

A total return investor spending 4% of his portfolio each year has an inflation adjustment built in to his plan. An income investor needs not only to make sure his investment income is greater than his spending, but also needs to make sure it will stay that way as the years go by.

The solution
Rather than focusing only on your investment yield, first build a reasonable, diversified, low-cost portfolio without considering the yield. Then, when it comes time to spend from that portfolio, use a combination of income and tax-efficient selling of assets to fund your retirement-spending needs.

Avoid an extreme position on income in order to develop a successful investing plan.

 Are you an income investor, a total return investor, or some combination?