August 08, 2020
Andrew Marchant

Time to Embrace Diversification and Total Return

In an environment of diminishing income returns a different approach to funding cashflow is required. This approach seeks to take advantage of the diversification benefits and growth potential from lower yielding assets and adopting a ‘total return’ mindset.

Whilst the fundamentals of portfolio management remain the same, the economic and financial settings imposed by Governments and Central Banks to combat the crisis have substantially altered the investment landscape.

Investors who built their portfolios the old-fashioned way – around generating ‘income’ to fund expenditure – may need to rethink things. The classic ‘barbell’ of high dividend stocks (or property assets) on one side and term deposits on the other is no longer providing the income that investors have become accustomed to.

With dividends being cut by 30% or more, the cash rate sitting at 0.25%, term deposit rates below 1%, and rents under threat, passive cashflows from portfolios are well down. Meanwhile, those ‘high dividend paying stocks’ (notably banks and other financials) have suffered significant capital impairment and appear to be among the riskiest in this Covid environment.

Many investors who have deployed this ‘tried and tested’ approach are now facing the challenge of how to fund their lifestyle. The solutions often range from cutting expenditure to match their income to seeking out investments that promise higher yields. These approaches can lead to diminished standard of living and higher risk outcomes.

Now more than ever investors need to embrace modern portfolio theory and the concept of total return investing. This contemporary approach involves considering your portfolio from the top-down and thinking of it as an integrated whole, rather than a basket of isolated parts.

Using this framework, the investor’s cashflow requirement comes from the total return of the portfolio, and isn’t confined to the interest, dividend or rental income stream. Sometimes this means the cashflow is coming from a mixture of income and capital, and this is ok – so long as the total portfolio return is exceeding the cashflow draw.

The key to modern portfolio theory is understanding that the necessary elements in the portfolio will behave differently at different times, offering the opportunity to take profits when certain parts are doing well, in order to top up other parts that have been under-performing. To make this work, the various components need to have low correlations to each other.

This approach unlocks a wider range of traditional investments for portfolio inclusion, such as lower yielding bonds and international shares, as well as companies in the Australian share market with low or no dividend yields. These assets can add meaningful diversification benefits and the potential for higher capital growth. Coupled with systematic rebalancing to provide a source of regular cashflows investors adopting this approach are able to alleviate concerns around funding lifestyle requirements without taking unnecessary risks. 

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