Portfolio income is a very important part of investment total returns. Far too often though investors only focus on changes in a stock or fund’s price, giving an incorrect picture of their portfolio returns.
What is portfolio income?
Portfolio income is paid out to investors, as cash or additional shares. This income is in addition to any changes in share prices and contributes to a portfolio’s total return. The two sources of portfolio income are interest from bonds and dividends paid to stockholders. (What are stocks? Here’s an explanation.)
What are dividends?
Many companies have reached a point where they generate substantial profits each year. When this happens the company’s board of directors can decide to pay out a portion of the profits to their shareholders. Not every profitable company pays dividends though. Management decides the best use of profits, often using some for continued growth and some to reward investors.
Why dividends for income versus bonds?
Bonds do a good job of stabilizing a diversified investment portfolio against economic downturns. When stocks do poorly, bonds tend to do well. But many people think of bonds for income – especially in retirement. In reality, though, the income generated from bonds over the past 10+ years really hasn’t been that great.
Bond yields have been rising a bit recently along with interest rates. Even so, the Vanguard Total Bond Market ETF (BND) is currently paying just a 2.50% yield. Let’s compare that to the SPDR S&P 500 ETF (SPY) which is currently paying a 1.92% dividend yield. [Both of those yields are as-of April 7th 2017.]
Portfolio income and total return
The Total Bond fund is paying more income than the S&P 500 fund – so that’s the better choice, right? Portfolio income is an important part of an investment’s return, but it is only part. To understand the true return of an investment you need to look at changes in the stock or fund price in addition to any income paid. This is referred to as an investment’s total return.
Let’s look at some information and charts to help understand total return.
This first chart and data set is for the Total Bond fund mentioned above.
If you put $10,000 into that fund ten years ago, your investment today would be worth $14,146.93. That’s a total return of 41.46% in a 10-year period. A more common way to express investment returns would be the average annual return. In this case, the average annual total return of this investment would be 3.53% per year.
While that isn’t horrible, let’s consider if you put the same amount into the S&P 500 index fund mentioned above.