Sunday, April 23, 2006

Unnecessary distinctions between capital and income, and underestimating the impact of REIT yield crashes...

Inspired by comments on Miserly Bastard's latest post...

I'm sure many economists/personal financiers have commented ad nauseum on how for retirement, one shouldn't necessarily distinguish between income and capital -- instead, one should invest for total return.

There are caveats:
a)tax reasons for distinguishing between capital gains and income, of course (though for instance, long term capital gains are taxed less than interest (for most reasonably wealthy people) -- on the other hand, dividend taxation has been made consistent...). In practice, irrelevant if held in retirement accounts, and you aren't planning to rebalance for tax reasons.
b)mental bucketing/mental cost reduction (insofar as people tend to either spend too much if they can't clearly distinguish between "assets" and "income," and insofar as it makes it easier for people to spend the appropriate amount each year)

Beyond that, why the distinction between capital and income -- why wouldn't you just invest for total returns?

People look at a portfolio and think -- "Hey, my REIT's are yielding 8%, how much worse can they get?"

The thing is, when yields fall on REIT's, prices typically also fall.

I feel that lots of people erroneously believe that hi-yielding assets have a large safety cushion.

For instance:

Hey, I have an 8% yielding REIT that is $100 a share, and I own 1000 shares, so I'll make ~8k. Even if the yields fall to 4%, I'll still make 4k.

Here's the thing -- when yields fall, all too often rational market participants will revalue the REIT to meet the lowered cash flow stream.

So, if you're doing Monte Carlo analysis of how REIT yields (in % terms) crash in bad states of the world, and you think, "hey, at worst 8%->4%," you're ignoring the fact that the stock price probably went from $100->$65.

Thus, in $ terms on your original portfolio of 1000 shares:

a)your expected future income went from 8k to:
4% x $65 x 1000 =$2,600, which, in terms of your original portfolio, is an effective 2.6% yield
b)your immediate wealth today just went from $100,000 to $65,000, or -$35,000


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