When markets become volatile, it is easy to find ourselves checking portfolio prices more frequently than usual. The numbers move, the headlines change, and suddenly the portfolio seems to demand more attention than it normally does.
But how much of our portfolio returns actually come from dividends and distributions, and how much comes from price movements? It is a question that is surprisingly easy to overlook.
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Two Ways a Portfolio Makes Money
There are broadly two ways an investment portfolio generates returns: capital appreciation and income. The oft-cited formula is simply: total returns = capital gains + income.
The key difference is that income can be realised without selling the underlying investment. A share price can fall tomorrow, but a dividend that has already been declared is not directly affected by tomorrow's closing price. Dividends and distributions are not guaranteed and can be reduced or suspended, but over time, a portfolio built to generate income can provide a stream of returns while the underlying investments remain vested in the markets.
Making Money While One Sleeps
In the Bedokian Portfolio, passive income is an important objective, as stated at the top of the blog. The five asset classes: equities, real estate investment trusts (REITs), bonds, commodities and cash, serve different purposes.
Both equities and REITs provide dividends, with the former having higher potential capital growth; Bonds give a stabilising effect when equities and/or REITs are weakening, while still earning coupon payouts; Commodities, though it is a non-yielding asset class, give the necessary softening of the overall portfolio from volatility; Cash, though acting as a pool of liquidity, could still be an interest-bearing instrument.
Not Losing Sleep Over It
If an investor has to sell investments to fund every dollar of spending, market prices become critical at the point of withdrawal. A downturn can therefore become more than just a paper loss. With sufficient passive income, some expenses can be funded without having to sell the counters.
A thing to note, however, is this: Passive income does not eliminate market risk. It reduces our dependence on market prices when one needs money.
This is where the traditional Safe Withdrawal Rate (SWR) framework meets the real-world psychology. While an SWR model generally assumes withdrawals from the portfolio to fund retirement, relying on income generated by the portfolio can provide an additional buffer, reducing the need to sell during sharp market drawdowns, at least from my perspective.
The Connection to Financial Independence or Step-Down
This becomes particularly relevant at the point of financial independence, or a partial one in the form of a “step-down” in our lingo, when employment income starts giving way fully or partly to portfolio income. The objective is not simply to reach a particular portfolio value, but to build a portfolio capable of generating sufficient and sustainable income while still allowing capital to grow.
Capital appreciation tells us how much the portfolio has grown. Income tells us what the portfolio can do without having to sell it. And perhaps knowing that our portfolio can continue to provide for us, even when markets are unsettled, is another way of sleeping well at night.
Related post
The Rationale Of The Asset Classes: The Bedokian Portfolio 300th Post Special
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