Against the backdrop of recent bank failures, stubbornly high inflation, and uncertainty around future interest rates, traditional fixed-income investments such as bank accounts, CDs, and government bonds, aren’t providing investors with the same level of comfort they once did.

Maybe it’s time to refresh our thinking about where to invest a “fixed-income” allocation within a Financial Independence (FI) portfolio.

Let’s start with why we invest in fixed-income investments in the first place. Generally, for three reasons:

• #1- stable and predictable cash flow (e.g., interest income)
• #2- the relative safety of our capital, and
• #3- a need in our overall FI plan.

If traditional fixed-income investments are part of your plan and your cash is coming up short, dividends might help fill the gap.

You Can’t Avoid Risk, But You Can Manage It

Before we move forward, a quick refresher on “risk” which we explored in One Definition of Risk for All of Us. We don’t look at short-term price volatility to measure risk but rather we define our risk in more practical, personal terms: Our principal risk is falling short of our cash spending goals.

As a result, in the short-term, we want to rely as little as possible on the sale of stocks to cover cash flow needs. As we all know, there is nothing ‘safe’ about being forced to sell stock to generate cash when the markets are falling.

So, what if you don’t need to sell stocks in the short-term and are comfortable with their long-term prospects? Well, price volatility becomes much less concerning and the cash dividends that stock funds generate can now move into primary focus.

"Do you know the only thing that gives me pleasure? It’s to see my dividends coming in." - - John D. Rockefeller

Interest And Dividends Working In Tandem

As background, here is a high-level view of just a few income opportunities along the yield spectrum:

As you move up the yield curve from traditional fixed income investments to equity funds you also will get more volatility in market prices - - but again, do we care?

Price volatility is not a concern provided (a) we have no intention of selling our quality fund choices, (b) we are at minimal risk of being forced to sell in the short-term in order to generate cash, and (c) we can control our emotional response to inevitable market drops.

By no means are dividends guaranteed, but historically, dividends have been significantly less volatile than stock prices. Since World War II, there have been 11 bear markets defined by a 20% or greater drop in the S&P 500 Index (excluding the COVID-19 induced drop which has yet to completely play out).

In three of these bear markets, dividends increased. In seven of the remaining eight, the average peak-to-trough decline in dividends was just 3%. The one outlier is the 2008-09 financial crisis which saw the S&P 500 Index drop 57%. The dividend decline was 23%, less than half of the Index price drop, and in four years dividends recovered to their pre-crisis level.

As In The Game Of Chess, See The Whole Board

Before you go off chasing higher yields, be sure to address reason #3 that we mentioned at the outset: What is the need in your plan that you are trying to fill? Always take a step back and view investment selection and asset allocation within the context of your entire financial plan.

If, for example, bank CDs are part of your plan, and you are meeting your overall cash needs, be happy. The fact that CDs (one sliver of your plan) are delivering less than inflation or less than the stock market is irrelevant.

There is no reason (from a mathematical perspective) to stretch for more yield when your plan doesn’t need it. Why jeopardize what you have and need to chase what you don’t have and don’t need? Remember, you are not investing to beat inflation, an arbitrary market benchmark, or your neighbor, but rather to meet your cash spending goals.

A Thought Experiment

Let’s assume a benevolent billionaire offered to give you more cash than you could possibly spend in your lifetime or even your children’s lifetime. Fantasize about what that number would be…now double it. That is your offer.

This pot of money comes with only one stipulation: you must keep any unspent cash in a bank vault earning nothing, zip, zilch. Which response is most aligned with your thinking: (a) ‘No thanks, a negative real return on my cash would be foolish,’ or (b) ‘Thank you and can I buy you dinner?!’

Don’t fail to see the whole board.

I am not advocating for replacing your entire fixed-income allocation with equities, but I am suggesting that well-diversified, high-quality dividend-focused funds are worth a look.

As always, invest often and wisely. Thank you for reading.

The content is for informational purposes only. It is not intended to be nor should it be construed as legal, tax, investment, financial, or other advice. It is merely my own random thoughts.

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