If you need to generate income from your investment portfolio to pay for expenses, the process of selecting investments can seem a lot more complicated. Since almost all bonds, many stocks, and some alternative investments provide periodic income in the form of interest or dividends, almost any portfolio will generate some cash. But in the current low interest rate environment, there aren’t many investments that yield more than a few percentage points.
Instead of trying to generate enough income by limiting your choices to only high-income investments, a better tactic may be a “total return” approach. This philosophy suggests ignoring your income needs when choosing your investments, and instead focusing only on selecting investments that create the portfolio most likely to have the highest total return (i.e. the combination of income and capital gains) for the amount of risk you’re willing to take.
If you need income from the portfolio, you can then “create your own dividend” by selling a portion of your holdings. For example, if your portfolio happens to only produces $1,000 of income but you need $3,000, you can simply sell $2,000 of your holdings to meet your income needs (of course your calculations need to account for how much you’ll owe the government, since interest income, dividend income, and capital gains are all taxed).
With this approach you can maintain a better-diversified portfolio: focusing on hitting a specific income target can result in a portfolio too heavily weighted toward bonds or too heavily weighted toward stock sectors (such as Utilities and Consumer Staples) that tend to pay higher dividends. By thinking about the total return rather than a specific income target, you don’t have to worry about your income needs skewing your portfolio.