Mostly about accessing a steady stream of cash flow, income investors invest in income-generating assets such as dividend stocks, bonds, and REITs. Johnson & Johnson (JNJ) stock offers investors a steady cash flow through dividends yielding roughly 2.5%. By contrast, total return investing emphasizes capital appreciation and plowing back of earnings to grow the value of the portfolio. During the past 30 years, the S&P 500 Index has delivered an average annual total return of about 10.7%, with just over half — or a solidly above-average-market rate — coming from capital appreciation at around 8.7%. Dividend-paying companies suit the requirements of income investors, which include lower volatility as well, and investment in low-volatility-high-dividends with similar levels of risk has typically been financial advice given to those taking this approach.
The core concept of income investing
Income investing is more about creating frequent cash flow from your portfolio and less about finding assets that you hope to hold for decades or a lifetime. The traditional income investor looks for assets that pay something out of their dividend or interest each year — they are not really interested in the current market value of assets. Johnson & Johnson (JNJ) has a dividend yield of 2.5%. For the last 58 years or so, Johnson & Johnson has paid out dividends, and for just as many consecutive calendar years, it has also hiked its annual payout. This means income investors can receive about $2,500 a year from owning the same $100,000 worth of Johnson & Johnson shares in a reasonably stable and predictable form.
Perhaps the most prevalent of all income assets is U.S. Treasury bonds in the bond market. The long-term U.S. Treasury bond, for instance, has returned an average of 2.7% annually over the last ten years or so. Treasury bonds are considered the (almost) safest investing asset, and therefore, they are used by those who do not want to take risks. Stable interest income and the return of principal at maturity are the main driving forces for buying such bonds. This stability of income is particularly important for people who depend on investment earnings to fund their day-to-day living costs or support their retirement provision.
Real Estate Investment Trusts (REITs) are another example of income investment vehicles. The Vanguard Real Estate Index Fund (VNQ) has returned roughly 9% per year, on average, over the last ten years, with almost all of that return originating from dividends. Purchasing REITs is an excellent way to generate above-average returns for income investors while also diversifying risk.
The core concept of total return investing
Total return investing is somewhat opposite to income investing, as it focuses on the growth of the whole portfolio based on capital gains and reinvestment. Total return investors are not only looking for cash flow from assets; they are also seeking to grow asset value over time and compound the realization of such effects. The S&P 500 Index has returned a total of ~10.7% per year over the last thirty years, and about 2% per year comes from dividends, with the rest — 8.7% — coming from capital appreciation during this period. If an investor placed $100,000 in the market in 1990, that investment would have grown to over $2.2 million by 2020.
Apple has risen more than 500 times just from 2000 to today. During this time of slow dividends, it is clear that increasing prices drove much of the total return for Apple investors. This growth strategy is not for investors seeking more conservative, cash flow-oriented income but is instead suitable for those with longer-term goals and comfort levels associated with increased risk tolerance, designed to deliver potential for significant wealth acceleration.
If you missed the dividend, a slightly different example is Berkshire Hathaway (no dividends), where stock value multiplied by thousands over the last several decades. In addition, intrinsic value can compound by reinvesting dividends in the stock of such a company, delivering total return investors both increases in total cash and capital appreciation.
Differences in investment strategies
Another major difference in strategy execution: Income investing suits the investor looking to generate higher returns with superior, consistent distributions. Utilities like Duke Energy are one example of a high-dividend stock that has, on average, paid about 4.3% per year in dividends and increased its dividend every single year for the last ten years. Because of this high dividend yield and growing dividends, many income investors like the stock. Another example is some large-cap blue-chip stocks, such as AT&T, offering a yield of more than 6%, making them very popular with investors focusing on income.
By comparison, total return investors seek companies with high growth potential, whether or not the company pays a dividend at all. Tesla’s stock has increased more than tenfold in value over the past five years, though it has never paid dividends. Tesla’s rapid growth and high future potential make it far more attractive to total return investors, who focus on long-term stock price appreciation over short-term cash flow returns. Amazon is another example — its stock price increased 200-fold in the past two decades, but it has never paid a dividend. Total return investors select these companies for their ability to increase in capital value over time, not for current income.
Different needs and choices of investors
Whether to use an income or total return investment strategy comes down to the investor’s personal circumstances — financial goals, needs, and risk tolerances. In fact, over 50% of retirement assets are placed in fixed-income spaces (bonds and high-dividend stocks), as evidenced by the folks at The Employee Benefit Research Institute (EBRI). This is done because these assets can provide uncorrelated yield to give retirees a source of relatively stable cash flow, enabling them to worry less about market downturns eroding their principal.
Most young investors in the savings stage choose total return investing. For example, if a young investor invests $5,000 per year with an average annual return of 10% starting at age 25, the investment will grow to over $2.5 million by the time they turn 65. This form of wealth creation is more appropriate for long-term investors with a higher risk appetite, as it involves capital appreciation and compounding over the years.
Risk management and diversification
Low-reward but low-risk options are chosen by income investors, and of course, you can reduce your risks by diversifying. A standard income portfolio may have 30% of assets in Treasury bonds, 40% in high-dividend stocks, 20% in REITs, and 10% in quality high-grade corporate bonds. This combination can be defensive in cash flow and somewhat protective in market downturns.
This contrasts with total return investors, who are more interested in the overall growth potential of assets and are willing to take on higher risk for greater returns. A total return portfolio could consist of 50% growth stocks, 20% international stocks, 20% small-cap stocks, and 10% high-yield bonds. While this combination may experience significant price shifts in the short term, its potential for substantial returns in the long run is the main selling point to investors.
