The big idea and why it matters: There are a select few investments that offer potential income growth AND price appreciation, and these primarily fall in two areas of markets – stocks (e.g., dividend growers) and Alts (e.g., real estate and infrastructure). I view these to be among the most important solutions for long-term financial planning success – i.e., for investors to not run out of money during their lifetime.
“You can be young without money, but you can’t be old without it.” – Tennessee Williams
A reminder of what “Fixed Income” means
You’ve probably heard someone say they “live on a fixed income.” It’s usually in the context of being retired and relying on a steady income from sources like a pension, annuity, and/or social security. Their income is capped, and aside from modest inflation adjustments (e.g., Social Security increases), it will remain at that amount.
I may oversimplify here to get the point across, but bonds are conceptually similar to the above example. It’s no wonder why they are literally referred to as “fixed income” in our industry. Bond investors are essentially signing up for a fixed coupon payment. If they buy a bond at a discounted price or we’re in a falling interest-rate environment, then there could be some additional price appreciation, but (again, keeping this simple) the core of the investment is that fixed coupon payment.
In other words, what we cannot expect from fixed income (aka bonds) is the opportunity for either a) a perpetually growing income stream or b) long-term price appreciation. Can you guess what two good investment attributes are for building long-term wealth and retirement income? Let’s get into that now. Here we go!
A growing income stream and price appreciation? Where do I sign up?
Imagine you have two investment options, which (very weirdly) are packaged in black boxes that will reflect the investment value on an ongoing basis. You don’t get to know the underlying investment strategies, but the boxes describe what they’re attempting to achieve. Here are your options:
Black Box #1:
- Cashflow: it pays you cashflow monthly at an annualized yield of about 4.5% – or about $4.50 for each $100 invested (each year).
- Cashflow Growth: the original $4.50 of cashflow is expected to increase by several percent yearly.
- Price Appreciation: it targets long-term growth of the invested amount – separate from the cashflows or cashflow growth.
- Pricing Frequency: The investment value will only be updated monthly, and many of equity markets’ wild ebbs and flows seem to be ignored.
- Taxation: much of the cash flow may be nontaxable, but the investment could be subject to capital gains and recapture.
- Liquidity: it may take a VERY long time to sell, and the sale price could be very different than the most recent value shown on the box.
Black Box #2:
- Cashflow: it pays you cashflow quarterly at an annualized yield of about 4% – or about $4 for each $100 invested (each year).
- Cashflow Growth: the original $4 of cashflow is expected to increase by a mid-to-high single-digit percentage each year (e.g., 5 to 9%).
- Price Appreciation: it targets long-term growth of the invested amount – separate from the cashflows or cashflow growth.
- Pricing Frequency: The investment value will update throughout each day – changing by the second – and it can be volatile at times, just like equity markets.
- Taxation: much of the cash flow may be tax-advantaged (long-term capital gains rates rather than ordinary income), and the investment could be subject to capital gains.
- Liquidity: it can be sold almost instantly, typically at the latest value shown on the box.
Which to choose?
Don’t think too hard; this isn’t necessarily an “either/or” question, and it’s often more of a “both/and” situation. If you haven’t already guessed, here’s what’s in the boxes: Black Box #1 is private real estate, and Black Box #2 is a higher-yielding Dividend Growth equity strategy (I know a guy). Both of these strategies can be viable options for long-term investors to help provide consistent, growing income and price appreciation.
I’m still in touch with many people holding excessive amounts of cash and feeling pretty good about the 5% yields they are still getting, but – as a reminder – cash is a terrible long-term investment option, even if it is currently yielding more than most stocks. Don’t fool yourself. If your cash isn’t earmarked for a near-term purpose (safety net or pending purchase), you’re doing yourself a disservice.
Why “60/40” Isn’t Good Enough
The 60/40 portfolio (i.e., 60% stocks and 40% bonds) came into existence in the first place to mix risk/return attributes that could help maximize return while reducing volatility. Another name for this is diversification. One only has to look back at 2022 for a glaring example of the limitations of such a strategy.
While we’ve been inundated with stories of stocks at all-time highs lately, we shouldn’t forget that simple index portfolios may still be underwater vs. where they ended 2021. According to my Tamarac screen, while the S&P 500 has returned 14.03% since the start of 2022 (through 3/21/24), the Bloomberg US Aggregate bond index is still -9.42% underwater. Thus, a 50/50 mix of those two indices has returned only 2.31% (cumulatively) over nearly two years and three months. And, if an investor with that same “50/50” portfolio has been drawing income from it, they still haven’t caught up to where they began. It’s worse outside the US, as a 50/50 mix excluding US stocks and bonds has returned -7.50% (50% MSCI All Countries World X-US / 50% BC Global Bond X-US).
As it’s the time of year when I’m having a lot of conversations with clients to put this all in perspective for them, I have been thrilled that our focus on Div Growth and Alts (often including, but not limited to, real estate) has allowed them to continue building wealth in a relatively steady way through the market roller coaster that we’ve endured since late 2021 (source: Tamarac, data thru 3/21/24).
The real black boxes
Just for some Alts-nerd fun, it’s worth mentioning that black box strategies have been around for decades. I remember them being more relevant in my work post-financial crisis when the early “liquid alts” (i.e., alternative strategies in daily liquid mutual funds) were gaining a lot of steam. In some cases, these things worked until they didn’t.
Feel free to check out this Investopedia page with a section on “Black Box Blowups” if you scroll down – citing black-box strategies getting crushed during Black Monday (1987), the LTCM failure in 1998, and the Flash Crash of 2015. Those models weren’t (and couldn’t have been) built to understand or react to such extreme and unprecedented events. This topic is something to keep on our collective radar, as (mentioned in the above link) the surge in computing power and AI may create more of these strategies. Stay tuned.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
