When many of us think of investment portfolios, our minds initially go to assets we hope will increase in value. The income portion of a portfolio has been less sexy over the last 15 years, as interest rates have been held at such historically low levels.
Traditionally finance has long used the 60/40 or 70/30 portfolios. These are allocations which are 60% equities and 40% income (or 70% and 30% respectively), where the income generally comes from bonds or dividend-paying stocks. The theory is that the equity portion tends to carry more risk and volatility, but also greater growth potential, while the income portion is “safe” money.
The planning generally follows the perceived risk. As you get closer to retirement, or some other goal in which you will need the cash, your portfolio moves more toward income, since you can’t “afford” to lose money in the market.
Income-based investments, therefore, have served a vital purpose in portfolios as a way to lower risk because the underlying asset is not thought of as volatile.
While taking some risk off the table, investors are still able to earn some yield on their assets, which can be used in a variety of ways. During the accumulation phase of life, which means pre-retirement, the income generated is usually plowed right back into the portfolio. During retirement, that income might be used for living expenses, and can greatly help the overall returns.
I have a portfolio that is 70/30, with the income portion earning me about 5% annually. That 5% can come from a combination of corporate bonds, real estate, and dividend-paying stocks. If the market is having a great year, my measly 5% looks pretty bad, and I may have the inclination to move to more equity so I can FOMO into those gains. However, the prudent action is to keep my allocation to prepare for a time when the market isn’t as kind.
In the following year, the market is off, maybe down 10%. The income I’m earning gives me the ability to purchase more equity at the lower value, without the need to sell any other assets. When the market rebounds, I’m in a better position, and the seemingly depressing 5% actually gave my portfolio a huge boost.
Now, we’ll take my portfolio to retirement age, when I may not choose to earn as much from performing work, but want to allow my savings to help pay my expenses. Each year, I need to draw down some of my retirement savings to fund my life. The income I derive from my investments can be used to fund some of my life expenses, allowing me to draw down less of the overall savings.
In a good market year, this might not seem significant, but in a down year, the ability to use income rather than sell equities at a less-than-opportune time is incredibly important. So many retirees run out of money just because the market was down during their first year or two of retirement, but they had to sell assets anyway to pay bills.
New opportunities to earn yield or income is one of the hallmarks of DeFi. Instead of having only bonds issued by companies, or stocks that pay dividends, I can lend, be a liquidity provider, or stake my digital assets. Some of these DeFi-related yield opportunities involve stablecoins, while others rely on more volatile digital assets like ETH.
There are certainly additional risks associated with finding yield in DeFi: technical, smart contract, impermanent loss, and volatility risks, to name just a few. However, we also have the ability to hold an asset like ETH, which we think has a great upside, and earn yield as we hold.
The perception, and the practice of separating a portfolio into the more volatile, but higher growth equity, and the more stable, income-earning portions will be altered as we adopt crypto and DeFi more. We can earn yield on high-growth assets, while also having the ability to make extremely customized hedges for our portfolios.
The ability to earn income on assets is among the top benefits of decentralized finance, and the way we learn to build portfolios in the new ecosystem will change the concepts of portfolio allocation for the next generation of investors.
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