Are You Investing for Income or Capital Growth?
Did you know a collapse in interest rates has made it more difficult to rely on interest from bank deposits as a source of income? Getting your head around investing for income can be a difficult task. To make it easier to understand, take a look at the 5 key indicators below.
1 – The Investment Alternatives
The income yield that an investment provides is its annual cash flow divided by the value of the investment.
Have you ever considered the alternatives to cash? Many others can provide yield or income such as shares, infrastructure and property. As with most things, there is a risk/reward trade off. Bank deposits are perceived by many as low risk (which can be questionable based on the graph below) where as there is a perception that higher yielding investments usually come with a higher level of risk.
2 – Gap between Yields as a Guide
The chart below provides a guide to relative value by comparing yields, showing shares and unlisted commercial property as attractive alternatives to bank deposits.
Share and property yields haven’t gone down despite bank deposit rates having fluctuated as shown below. Unlisted infrastructure, commercial property and Australian shares are shown as providing additional value based on the 20 years of data presented. Which makes the perceived security of bank deposit a little uncertain.
3 – Shares Can Provide Stronger Growth
Shares have historically provided stronger growth in income as shown in the graph below. A well-diversified portfolio may provide a smoother investment experience than those that have their eggs all in one basket. The question is, what is most important to you? An investment which is stable or one that fluctuates but historically returns more over the long-term?
4 – Security from a Sustainable Income Yield
A high and sustainable income yield from an investment has the potential to provide security during volatile times. Since 1900 dividends have produced over half of the 11.8% average annual return from Australian shares and this is reflected in the contrast between capital value and return from shares in the graph below. But don’t get caught out by the yield trap (point 6). It is an indicator of income but can be deceiving at times.
5 – Yield as a Guide to Future Returns
The income yield an investment provides is the key to building its total return, explained in this simple calculation:
Total return = yield + capital growth
Typically, the higher the yield of an asset, the higher the return is likely to provide (But don’t forget the yield trap… point 6). In relation to the bonds chart below, it shows a scatter plot of Australian ten-year bond yields since 1950 against the ten-year bond yields. When bond yields are high, they drive high bond returns over the medium term and vice versa. While returns have been solid as of late, low investment yields warn of lower returns ahead, in particular from government bonds.
6 – Don’t get caught out by the yield trap!
With yield being an indication of possible return from an investment, it may increase if both the dividend payout increases and the asset value remains the same or if the asset value decreases and the dividend remains the same. So an increasing yield isn’t always a positive sign of expected income if the decrease in asset value is an indication of potential underlying issues (keeping in mind that the GFC saw asset values swiftly decline, not always indicating potential underlying issue with the companies involved). However, in many instances, the return from an investment may increase as the asset value increases. Resulting in both income and capital growth. In this instance, the yield of the asset may not change too much.
To understand the true yield of an asset, the yield may be considered based on the value of the asset at its purchase date. For example, if an asset was purchased for $20, and the annual return is $1. The yield is 5%. If the return increases to $1.50 the following year and the value of the asset increases to $22. The advertised yield would be 6.8%. However, if the asset was purchased at $20. The real yield on that investment would be 7.5% (1.5 divided by 20).
Yield is an interesting indication of possible return from an asset. But as you can see from the example above, don’t get caught out by the yield trap! Consider the yield on the asset based on its purchase price.
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