Separating the Variables #2: The Concrete Version
I got a really good comment on the last post asking for some more fundamental clarification on the terms. I actually think it gets right to the heart of why this stuff is easy to mix together, so it is probably worth slowing down and making the distinction more concrete.
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Yield is how much cash the portfolio distributes relative to its value. If a $100,000 portfolio pays $5,000 in dividends or distributions over a year, that is a 5% yield.
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Total return includes both the distributions and the change in the value of the investments. If that same portfolio pays $5,000 in distributions and also rises $7,000 in value, the total return is 12%.
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Withdrawal rate is how much of the portfolio you actually consume. If you receive $5,000 but spend only $2,000 and reinvest the other $3,000, your withdrawal rate is 2%.
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Those three numbers are related, but they are not interchangeable.
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This is where the percentage of distributions being reinvested can become misleading. Saying “I spend half my dividends and reinvest the other half” might sound conservative, but the reinvestment percentage alone does not tell us the withdrawal rate. We also need to know the yield.
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If a $100,000 portfolio yields 10%, it distributes $10,000. Spend half and reinvest half, and you are withdrawing $5,000, or 5% of the portfolio.
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If another $100,000 portfolio yields 20%, it distributes $20,000. Spend half and reinvest half, and you are withdrawing $10,000, or 10% of the portfolio.
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Same reinvestment rule, but one portfolio has a 5% withdrawal rate and the other has a 10% withdrawal rate. That is why the percentage being reinvested is not really the variable we want to use to judge how conservative the spending is.
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The comment also brought up another intuitive way of thinking about this: reinvesting enough of the dividends to keep buying additional shares, with the idea that continuing to add shares helps keep the portfolio sustainable.
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There is nothing wrong with that as a personal accumulation milestone, but let’s put some numbers around it.
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Suppose you have a $5,000 position that distributes $500 over the year, so the yield is 10%. You spend $300 and reinvest the remaining $200. If the shares happen to cost $200 each, that reinvestment buys exactly one additional share.
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So now we know:
Shares purchased from distributions = 1
Withdrawal rate = 6%
Total return = ???
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We have successfully added another share, and we can calculate that $300 of spending from a $5,000 portfolio is a 6% withdrawal rate. But we still do not know whether that 6% withdrawal is sustainable because we have not answered the total return question.
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If the strategy is generating a sufficiently high total return with an acceptable level and path of risk, perhaps that withdrawal can be supported. If its total return is substantially lower, buying another share with part of the distribution does not fix that problem.
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That is the part I think can get lost when we focus on the number of shares or the percentage of distributions being reinvested. Both can be useful ways to organize your cash flow, but neither tells us how much economic return the portfolio actually generated.
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A distribution is not automatically a return. A portfolio can distribute 10%, 15%, or 20% without generating a 10%, 15%, or 20% total return.
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So the cleaner way I think about it is that yield tells you how much cash was distributed, withdrawal rate tells you how much of the portfolio you consumed, and total return tells you how much the investment actually earned.
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Reinvesting more can absolutely reduce your withdrawal rate, and buying additional shares can be a perfectly useful accumulation goal. But neither one answers the sustainability question by itself.
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For that, we still eventually have to ask the same two questions:
How much of the portfolio am I withdrawing?
What total return and risk is the portfolio producing?
