Income vs. Total Return: Why Take Sides?

Moreover, what would seem to be another big ideological fissure between the incomeniks and the totalniks--whether you tap your principal or not--is not as big a division as it might seem.

True, the goal for many income investors is to not touch principal but rather to fund expenses with the income that their portfolios generate. By contrast, total-return investors don't reflexively avoid tapping capital to fund living expenses. But that doesn't mean that total-return investors favor blithely tapping capital until it's all gone. Rather, the goal of the total-return strategy is to grow the overall investment by maintaining a diversified basket of investments--some income-producing, some that will contribute to the bottom line by appreciating in price, and some that do both. When you get down to it, we're really discussing a difference in logistics--how you extract capital from your portfolio--more than a grand ideological divide. The big-picture goals of growing and maintaining a portfolio are the same for both income and total-return investors.

Combination of the Two

In the end, I think the best answer for most investors is to give due consideration to securities' income-generating potential but within a total-return framework.

Blending the two approaches allows investors to benefit from the stability that income-producing securities bring to the table without sacrificing diversification or chasing securities that, in hindsight, turn out to be yield traps.

And employing a total-return approach has benefits not readily available to investors focused exclusively on income. One of the key benefits would be the ability to diversify across more security types than might naturally appeal to investors who are anchoring on securities' current income generation. High-quality bonds and cash provide an excellent case in point right now. It's hard to argue that their yields are attractive, and the prospect of higher interest rates looms large for longer-term bonds. But as the market sell-off in the second half of 2011 amply illustrated, such securities can provide valuable stability at a time when equities--including, yes, dividend-paying stocks--are cratering. The same goes for small-company and growth stocks. Although it's true that many of them don't pay dividends, they still can lend a performance-smoothing effect to a portfolio anchored in blue-chip dividend payers.

Another benefit of a strategy that combines income with total return is the ability to be strategic about which assets get tapped to meet income needs. A retiree might choose to fill up the income bucket using dividends or bond income, but he might also use the proceeds from rebalancing.

The bottom line? Resist the urge to classify yourself as either an income or total-return investor. When it comes to the health and stability of your portfolio, the best answer is "both."

Christine Benz is Morningstar's Director of Personal Finance.