The Secret Sauce

April 12, 2023

There is a common misperception we run across in the marketplace. When people hear income, they think of bonds. Bonds = interest payments = income. They don’t think of stocks. That creates some problems.  

It is often forgotten what a stock is. People remember it is ownership in a company. Perhaps they learned that in a finance class in college. It has been awhile, but they remember that. But they forget a stock is also a claim on a company’s future cash flows.

There are thousands (millions?) of companies out there and they all exist for the same purpose. They have marketing departments and hire consultants to convince you they have some unique purpose. Google says their purpose is to “organize the world’s information and make it universally accessible and useful.”[i] Nike says their purpose is “to bring inspiration and innovation to very athlete in the world.”[ii] That all sounds nice. But it’s not the core purpose for which Google and Nike and all the other companies exist. They exist to make money. More specifically, to generate profits – revenue in excess of their costs. That is their purpose.

Purchasing stock in Google or Nike or any other publicly traded company (or buying ownership in a private company via private equity or venture capital or buying into the family business, etc.) is simply purchasing a claim on that company’s future cash flows. The company exists to generate cash flows. That is the whole point. When you buy stock, you buy a claim on some of that cash in the future. When shareholders receive those cash flows it is called a dividend. If you own stocks or equity mutual funds or ETFs, you earn dividends. They are likely automatically reinvested, so you may never really notice them. But you are an owner of those companies and (most of) those companies pay out some of their profits to you proportionate to your ownership. Most of the S&P 500’s constituent companies pay dividends – the dividend yield on the index is currently 1.74%.[iii] That sounds low, but we’ll get to that.

A quick note – some companies don’t pay their owners dividends right now. These are often called growth companies. They take all their excess profits and reinvest them in their business. Investors in these companies want them to reinvest their profits rather than pay a dividend if they believe it will cause the value of the company to grow. That is good for the investors. Tesla has never paid a dividend. Not once. Elon has managed to reinvest his profits for the benefit of the company (that is, its shareholders). Tesla’s stock price is up over 6,000% over the last ten years.[iv] Tesla’s long-term investors are happy. They buy Tesla stock because one day Tesla will begin paying a dividend (future cash flow) and it’s better for shareholders if Tesla is a massive, well-established company that can’t get a better return by reinvesting their profits before they begin paying a dividend. Investors in growth companies that have never paid a dividend are still buying a claim on future cash flows, but to quote Aragorn, “today is not that day.”

Now, bonds. People think of income when they hear bonds because bonds immediately pay interest at their stated rate. When you buy a bond, you are loaning money to a company or a government for a period of time in exchange for interest payments. US government bonds (“Treasuries”) are well known. Today you can hand the US government $1,000,000 for 30 years (that is, buy a 30-year treasury bond) and they will pay you 3.6%[v] – $36,000/yr. – for the next 30 years and then hand you your $1,000,000 back in 2053.  

People are starting to get riled up about treasuries. Who expected treasury bonds would ever be exciting? Yet here we are. Interest rates have been low for a long time, and investors are excited about getting more than 3% on “risk-free” treasuries. Admittedly that is much better than the 0.99% you could get in 2020![vi] Yes, in 2020 the US government paid people $9,900/yr. to hold onto their $1M for 30 years. People really looked at that deal and said, “I’ll buy!”

So the yield on the 30-year is currently 3.6%, while the dividend yield on the S&P 500 is 1.74%. The retiree or soon-to-be-retiree who wishes to create income from his investment portfolio over the next few decades often performs the following analysis:

30-year treasuries pay me 3.6%

The dividend on the S&P 500 is 1.74%.

Gimme those treasuries!

Very understandable, but… this is what the fancy academics call a univariate analysis. It only considers a single variable. And there are some other rather important variables to consider. Principally, (a)capital appreciation and (b) cost of living.

Today and tomorrow’s retirees are not simply in search of income. They are in search of income that meets or exceeds their rising costs over the next ~30 years. Rising costs is merely inflation by another name, which we have all become well acquainted with. A couple retiring in 2023 will find a carton of eggs, a gallon of gas, a trip to the doctor’s office, and everything else will be a lot more expensive in 2053.

Let’s say you have $1,000,000 and you need to create income for a thirty-year retirement. We’ll compare investing that $1,000,000 in the S&P 500 index (our proxy or “stocks”) and buying a 30-year treasury bond.

Obligatory disclaimer that you cannot invest directly in an index and any investor will likely incur trading costs, fees, etc. that are not included in the below analysis.

First, the treasury bond. As mentioned above, the 30-year treasury currently yields 3.6%. Here is a quick summary of your hypothetical 30-year retirement:

First annual dividend check (2023):               $36,000

Last annual dividend check (2053):               $36,000

2053 Purchasing power in 2023 terms:         $14,832

Balance in your account (2053):                    $1,000,000

This is a succinct demonstration of the issues of (a) capital appreciation and (b) cost of living. Over 30 years, your capital appreciation is $0. You handed the government $1,000,000 in 2023 and they handed you $1,000,000 back in 2053. Meanwhile, the purchasing power of your annual interest payments – your income – has been cut in half and then some. At a 3% inflation rate, $36,000 in 2053 will buy what $14,832 buys in 2023.

Now, let’s say you invest $1,000,000 in the S&P 500 index. The dividend yield on the index is currently 1.74%. Over the last 30 years, the index (without dividends reinvested – you’re taking those as income in this thought experiment) has returned 7.7%/yr.[vii] Assuming a consistent 1.74% dividend yield and 7.7% annualized returns moving forward, here is a snapshot of your hypothetical 30-year retirement:

Annual dividend income (2023):                     $17,400

Annual dividend income (2053):                     $161,072

2053 Purchasing power in 2023 terms:          $66,359

Balance in your account (2053):                     $9,257,018

It seems we’ve solved the issues of capital appreciation and cost of living? Note that while the bond investor’s purchasing power has been cut in half (and then some) over thirty years, the equity investor’s purchasing power has increased nearly four times. And remember 1.74% sounding boring? Well your $161,072 annual dividend income in 2053 is simply 1.74% of your $9,257,018 portfolio balance. It is the same 1.74% yield on the index, but that last annual payment of $161,072 is a 16.1% yield on your original $1M investment. Simply comparing stock and bond yields often leads one astray. There is a difference between a yield on a stagnant balance and a yield on an increasing balance. A pretty big difference, it turns out…  

So today a long-term bond earning just under 4% sounds appealing when compared to an equity index yielding just under 2%. Particularly for the retiree or soon-to-be-retiree looking for income. But that’s not the whole story.

Some may look at the above analysis and say something like, “aha! You have forgotten that dividends are not guaranteed – that is an important variable you failed to consider!” A fair point. Dividend payments are discretionary, while interest payments are contractually guaranteed (assuming no issuer default). However, the dividend of the S&P 500 has proven very dependable. Companies are loathe to cut their dividend – doing so sends a message (“Hey everybody! We’re in trouble!”) to investors they do not wish to send. So much so companies have been known to borrow money to continue paying dividends to shareholders during difficult economic times. This helps explain why the chart of the S&P 500 dividend is rather smooth:[viii]

I should mention that the analysis – while multivariate – is still incomplete. It does not take into account taxes (though doing so would likely make equities look better than bonds…), nor does it take into account risk tolerance (any 30 year holding period for equities is bound to experience some nasty declines – the index was cut in half on two different occasions during the last 30 years).[ix] And of course a retiree with $1M would likely find it difficult to live on $17,000 of dividend income in year one.

Nonetheless, those considering transforming their investment portfolio into an income stream – as all retirees must ultimately do – ought to remember equities are simply claims on future cash flows and likely serve an invaluable role in a lifetime income and legacy plan.

I will leave you with this pleasing excerpt from Warren Buffett’s latest annual shareholder letter under a section entitled “The Secret Sauce,” which inspired the title of this post. Your capital levels may not approach Buffett’s, but that needn’t keep you from employing a similar strategy: 

In August 1994 – yes, 1994 – Berkshire completed its seven-year purchase of the 400 million shares of Coca-Cola we now own. The total cost was $1.3 billion – then a very meaningful sum at Berkshire.

The cash dividend we received from Coke in 1994 was $75 million. By 2022, the dividend had increased to $704 million. Growth occurred every year, just as certain as birthdays. All Charlie and I were required to do was cash Coke’s quarterly dividend checks. We expect that those checks are highly likely to grow.

American Express is much the same story. Berkshire’s purchases of Amex were essentially completed in 1995 and, coincidentally, also cost $1.3 billion. Annual dividends received from this investment have grown from $41 million to $302 million. Those checks, too, seem highly likely to increase.

These dividend gains, though pleasing, are far from spectacular. But they bring with them important gains in stock prices. At yearend, our Coke investment was valued at $25 billion while Amex was recorded at $22 billion. Each holding now accounts for roughly 5% of Berkshire’s net worth, akin to its weighting long ago.

Assume, for a moment, I had made a similarly-sized investment mistake in the 1990s, one that flat-lined and simply retained its $1.3 billion value in 2022. (An example would be a high-grade 30-year bond.) That disappointing investment would now represent an insignificant 0.3% of Berkshire’s net worth and would be delivering to us an unchanged $80 million or so of annual income.[x]

Sean Cawley, CFP®


Neither asset allocation nor diversification guarantee against investment loss. All investments and investment strategies involve risk, including loss of principal.

Content here is for illustrative and educational purposes only. It is not legal, tax, or individualized financial advice; nor is it a recommendation to buy, sell, or hold any specific security, or engage in any specific trading strategy. Results will vary. Past performance is no indication of future results or success. Market conditions change continuously.

This commentary reflects the personal opinions, viewpoints, and analyses of Resolute Wealth Management. It does not necessarily represent those of RFG Advisory, clients, or employees. This commentary should be regarded as a description of advisory services provided by Resolute Wealth Management or RFG Advisory, or performance returns of any client. The views reflected in the commentary are subject to change at any time



[iii] YCharts, S&P 500 Dividend Yield.

[iv] YCharts, TSLA Price, 10 Years (ending 04/05/2023).

[v] YCharts, 30 Year Treasury Rate, YTD

[vi] YCharts, 30-Year Treasury Rate, 01/01/2020 – 12/31/2020

[vii] YCharts, SPX Level, 04/05/1993 – 04/05/2023

[viii] YCharts, S&P 500 Dividend, 01/01/1946 – 12/31/2022