7 per cent a year difference in income returns
LAST week we talked about the impact of inflation on your income. A 72 per cent return was needed over 20 years just to keep your money level with inflation.
Investors can take income from investments in many ways, but some strategies have the income tail wagging the dragon, let alone the dog.
Investors can look to natural ‘income' such as dividends or fixed interests, where the ‘flow' of income is perceived as organic and natural, when in effect it may not be so.
Those of us approaching, or in, retirement, have to rely on an income for much longer than before, and that in more market sensitive times. Few individuals buy the guaranteed income an annuity offers, and many have also transferred out of occupational schemes where income was guaranteed.
Due to the length of time (and not knowing the length of time) investors need money to live, they will not only need income, but also capital growth to keep pace with the aforementioned rising costs of living. Income without growth is a tail without a dog.
The lure of pure income assets such as dividends has been an historic one. Dividend-focussed companies' shares are purchased for the attractive income which of course increases their share price – the ultimate attractive reinforcing loop.
Companies can remain attractive by redirecting profits to dividends rather than future growth plans, and so growth can fall away, alongside the future share price.
Managers then look to their balance sheet rather than future growth, to sweat every asset within the organisation and streamline to the finest margin for their EBITDA (a measure of profit).
They forget their ‘why' in their business - the burning reason they were in business, and why their customers love and adore them, and instead, stretch the elastic for profitability, until it snaps right in their eye.
Such higher dividend stocks are more likely to be found in the ‘value' theme rather than ‘growth' and that is why investing to just one theme is not going to add the same returns to your investment income portfolio over the long term.
No one is better than the other. That's a bit like comparing a fast car and a four wheel drive vehicle. Best of luck in the snow with one of them, but a household with both cars is a bit more secure.
An investor fully invested in income stocks from 2009 to 2018, would have been 144 per cent in returns worse off, than an investor in growth stocks. That's over 7 per cent per year difference. If I compared the performance from 2000 to 2018, value stocks outperform growth by a staggering 157 per cent.
An investor in just growth stocks doesn't enjoy the same softened curve in pursuit of their gain however.
If you look at historical charts, growth and value run in different cycles. Trying to jump between them is a tricky task, like hoping it won't snow on your Ferrari journey in January. It might not, and you get home quicker than everyone - but, conversely, you might get the odd ‘ha, ha' as you are sat on the side of the road for the night.
Growth stocks tend to retain their earnings to fuel future growth whereas value will pay out a greater portion in dividends, resulting in slower growth. They are two types of companies at different stages in their life. Motorway driving versus the snow.
Stocks are often valued on a price earnings ratio P/E (price of the stock divided by its earnings per share). Growth stocks normally have a higher P/E ratio as they are pricing in future growth in cashflow, revenue and profit, and so can be perceived as more volatile, i.e. the money isn't there yet.
Value stocks (where the higher dividends come from) are generally seen as undervalued in the market. They are the ‘nice to have' stocks that will hopefully be spotted and the price will rise, and are seen as less risky, and less expensive generally than growth stocks.
In building your income portfolio, focussing on growth at a reasonable price by blending your income strategy, will take you closer to beating inflation and maximising the above wildly varying returns.
:: Peter McGahan is chief executive of independent financial adviser Worldwide Financial Planning, which is authorised and regulated by the Financial Conduct Authority. If you have a question on how to blend your income requirements call Darren McKeever on 028 6863 2692, email email@example.com or visit www.wwfp.net.