Capturing the Investment Return

Dividend strategies are best. They allow you to capture the investment return.

The Investment Return

The Gordon Model (and other variants of the Dividend Discount Model) adds the initial dividend yield and the dividend growth rate (annualized) to calculate the Investment Return. The Investment Return depends on business conditions. It is reasonably stable.

The Gordon Model works well for time periods of 5 to 15 years. Outside of that range, it fails because available investments no longer satisfy theoretical assumptions.

To determine the total return, it is necessary to add an adjustment for changes in multiples (i.e., prices paid for dividends). This is called the Speculative Return. It is subject to popular whims. It fluctuates considerably.

In today’s market, multiples are exceedingly high. Multiples are likely to contract. The likely Speculative Return is negative.

Unlike traditional, fixed allocation, liquidation strategies, dividend strategies focus on the Investment Return. Retirees are much better off following dividend strategies.

What I Discovered

I was examining a series of Stock A/TIPS conditions on my TIPS Income Stream Allocator B. I started with an 80% Stock A allocation. [Stock A is an investment type, not a specific stock. I characterize it by its initial dividend yield and its nominal dividend growth rate (annualized).]

TIPS (or other cash equivalents) are used for managing the cash flow, not as a primary investment. By managing cash flow, I am able to generate a steady cash stream.

I noticed that, with a 5% per year (annualized) growth rate, the (real) income stream was about 1% per year less than the Investment Return.

I increased the (annualized) growth rate to 10% per year. The income stream increased only slightly, but it grew dramatically after a few years.

Then I increased the TIPS allocation from 20% to 40%. The income stream jumped dramatically. I had not had a large enough TIPS allocation for the higher growth rate.

What I discovered was that the sustainable income stream can come within about 1% of the Investment Return by using TIPS to manage the cash flow. The reason for the loss is simple: TIPS have a lower Investment Return (2% per year after adjusting for inflation, the same as their interest rate). The Investment Return of the overall portfolio was lowered slightly via TIPS in order to maintain a steady income stream (after adjusting for inflation).

Instructions

Use the Income Stream Allocator or other spreadsheet to manage your income stream. Use a side account with TIPS and/or other cash equivalents to maintain a steady cash flow. Your income stream will come within about 1% of the initial dividend yield plus the annualized, nominal growth rate of the dividend minus the inflation rate.

You can improve performance by including a higher yielding Investment B with a (possibly) lower growth rate. Once again, you move money into and out of the TIPS account to maintain a steady cash flow.

You will need to look at several initial allocations to get the best results.

Have fun.

John Walter Russell
February 21, 2007