A widow in her late 60s came to me last year to talk about tax planning. She really liked our financial planning services, especially the tax planning piece. She had quite a few individual stocks and wanted to be sure she was tax-smart as she moved toward a more diversified portfolio.
One of her comments was “I want to be sure that I only use income from the portfolio and not my principal.” I then asked her how she determined what her “principal” was. Basically, it was whatever the recent balance was on her statements, but primarily when the number was higher. I explained how we think it is more important to use a “total return” strategy when designing a portfolio for income and not just use a stock that pays a good dividend.
From our experience, most people don’t realize that when a company pays a dividend, the price of that company’s stock goes down by the same amount of the dividend. It’s not always noticeable since there are other factors that influence the stock’s price on any given day that may mask the dividend payment adjustment.
If the company didn’t pay the dividend, they could use the money to expand operations or a host of other strategies that may increase the value of the company (and therefore its stock price). You could then sell some of the stock as you needed income, but only when you decided to, not when the company decided to pay you a taxable dividend. The goal, of course, is to generate a rate of return that is higher than the combination of the dividend payment and the increase in the share price of the stock.
This understanding of what actually is your principal is even more important to remember when stocks are struggling like they did in the first quarter of this year. Many analysts had been forecasting this downturn for quite some time—and it finally came to pass!
No one (and I do mean NO ONE) knows when/how long/how far/which way stocks will trend next, but it’s worth keeping the recent volatility in perspective.
A common phrase we hear when someone is talking about their investments after a market downturn is “I lost ‘X’ amount of money last month.” Did they really lose money last month? Obviously, it feels like you lose money when the account value goes down from a recent high, but did you really “lose” money? If you purchased all of your investments just prior to the price going down, you could argue that you lost money—even if it is only temporary. However, if you, like most people, had invested your money at least a year ago, or more, you didn’t really lose any money. You did lose the opportunity to lock in whatever gain the recent peak in price afforded you, but your principal remained untouched.
The main point for you to focus on is the concept of “principal preservation.” If you had originally invested in a “risk-free” investment such as a CD or US Treasury Bond, your account more-than-likely would not have grown nearly as much as it historically would have grown had it been invested in a diversified portfolio of stocks and/or bonds. This is all time-period dependent, but typically the diversified portfolio’s price will still be higher than the “risk-free” account, even after a downturn.
The takeaways for this are:
(1) Don’t be surprised (it’s okay to be disappointed, just not surprised) when your portfolio goes down in price—we can guarantee that it will go down, but we are also confident the price will go back up
(2) Don’t put all of your money into the stock market so that your entire portfolio doesn’t react negatively to stock price drops or depend entirely on the stock market for positive returns (the goal of a PlanFIRST portfolio)
(3) Since no one knows when the stock market has peaked and is about to drop or when it has bottomed out and is about to go back up, your stock investments should be considered long-term (5 plus years).
Most of you would be better off not watching financial commentators on TV, and let PlanFIRST℠ do the “worrying” for you!
