Should cash distributions drive investment decisions?

FinanceWealth-Building

  • Author John Raymond Leske
  • Published July 17, 2009
  • Word count 730

It is not at all uncommon for those in retirement and near retirement to be concerned about the amount of cash distributions their investment portfolio is paying. Often, their objective is to be able to live off this cash and, thereby, keep their initial capital intact.

Typically, such investors understand they need to be concerned about the long term safety of their portfolio. But, at the same time they require some scope for capital growth to avoid the possibility that they will run out of money.

Therefore, they tend to go towards a balanced/growth type portfolio, allocating 40-50% to what they consider "defensive" assets and 50-60% to "growth" assets. Provided their asset allocation has been determined appropriately (see "The Asset Allocation Decision"), this sounds eminently sensible.

However, their focus on cash heavily influences the types of "defensive" and "growth" assets they choose. These choices may, in fact, totally undermine their asset allocation decision.

When selecting "defensive" assets, they are attracted to higher yielding alternatives than offered by government and high credit quality private issuers. They consider such investments as mortgage funds, hedge funds and various types of hybrids. These are designed to look like fixed interest investments but with varying doses of equity risk thrown in. More potential cash is the lure.

For their growth assets, they are attracted to high yielding, fully franked Australian shares – particularly, bank shares. And, at least until 2008, high yielding listed property trusts appeared to offer both high cash distributions and some prospect of capital growth.

Many financial planners, particularly those with links to stockbrokers, are only too happy to help their clients build these apparently "conservative", cash rich portfolios.

More risk than meets the eye …

We believe that such portfolios are fundamentally flawed. They result in significantly more risk being taken than may be necessary or understood by their holders.

For a detailed view regarding of approach to investment, see "Foundations of Financial Economics". However, in summary, the shortcomings include:

  1. Maximisation of cash distributions is never likely to be an optimal objective for an investment portfolio. In most cases, the goal should be to maximise after-tax returns for the risk taken.

An investor should not care how returns come (i.e. as income or capital). In many cases, it may be preferable to sell assets (and even pay capital gains tax) to generate cash to live on, rather than hold inappropriate, high yielding assets;

  1. We think the purpose of defensive assets is to reduce risk and portfolio volatility, rather than to enhance return. Defensive assets should be as safe as practically possible, implying very high credit quality and short maturity.

High yielding fixed interest products always mean higher risk, although it may not be apparent. They are most likely to let you down when markets are under stress. Just the time when you are relying on the defensive component of your portfolio to do its job;

  1. If you need higher total returns, you should look for the growth component of your portfolio to provide them. Research has shown there is a structured way to take this "growth" risk (see "Risk and Return are related").

A concentrated portfolio of bank shares and/or listed property trusts would not be expected to provide adequate return for the risk taken; and

  1. A focus on cash returns is inconsistent with our view that you should diversify as broadly as possible to maximise after-tax returns for a given level of risk (see "Diversification is key").

For example, it will bias share selection to high yielding, fully franked Australian bank shares in preference to, say, lower dividend paying resources stocks or international shares. The resulting bias adds to your portfolio risk (it is called concentration risk), but has no expected return.

Total return for risk is what counts …

An objective of maximising cash distributions from investments is an example of what we consider to be a breach of the decision making principle of "It’s about ends, not means" (see "Foundations of Decision Making").

Usually, the appropriate aim is to ensure that there are sufficient financial returns to enable you to live the life you want. It really does not matter how the returns come i.e. as income (cash distributions) or capital growth.

What you need to be more concerned about is that the returns are adequate for the risk taken, the costs incurred and the taxes paid.

Wealth Foundations is an independently owned personal financial advisory firm that offers wealth management and strategic financial planning services. For more information, visit Wealth Management.

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