Most investors face a decision as to how much of their portfolio to allocate to growth investments and how much to income investments. The mind-set of many income investors is that they cannot afford the volatility of growth investments. The following example illustrates how income investors can use growth investments to protect their portfolio against inflation and enhance overall returns.
Growth investments, historically, have outperformed income investments, but at the expense of greater volatility. They are typically favored pre-retirement by investors with long time horizons who seek to maximise their capital on retirement. Other than improved performance, growth investments also generally receive more favourable tax treatment than fixed income, further enhancing after-tax returns. Income investments historically exhibit lower volatility and are favored by retirees for their consistent income, also by risk-averse pre-retirees who wish to reduce the volatility of their overall portfolio.
Historic Returns
These historic returns to Australian investors from 1981 to 2009 illustrate the differences in returns and volatility. Data was originally provided by AXA:
| Asset class: | Australian stocks | Australian fixed interest | International stocks | Australian REITS | Australian cash |
|---|---|---|---|---|---|
| Annualized return (%) | 11.38 | 10.41 | 10.81 | 10.49 | 9.18 |
| Inflation (%) | 4.41 | 4.41 | 4.41 | 4.41 | 4.41 |
| Real return (%) | 6.97 | 6.00 | 6.40 | 6.08 | 4.77 |
| Standard deviation | 23.32 | 7.60 | 21.41 | 18.75 | 4.95 |
Not all investment strategies are likely to match the broad asset classes, but they are a good starting point for developing a broad investment strategy.
What the future holds
One thing about the future is certain: it is not going to match the past. It also is not going to match our projections. Without a magic crystal ball, the best we can do is adjust past performance for expected changes and hope we are not too far off course.
My own expectations are that we are entering a low inflation environment. Central banks, after the global financial crisis, are likely to be far more vigilant about rapid credit expansion and asset bubbles. I have therefore adjusted my inflation expectation down to 2.0%. I also expect that low inflation will have greater impact on fixed interest and cash and have adjusted their returns accordingly.
| Asset class: | Australian stocks | Australian fixed interest | International stocks | Australian REITS | Australian cash |
|---|---|---|---|---|---|
| Annual return (%) | 9.00 | 7.00 | 9.00 | 8.00 | 5.00 |
| Inflation (%) | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 |
| Real return (%) | 7.00 | 5.00 | 7.00 | 6.00 | 3.00 |
| Standard deviation | 25 | 10 | 25 | 20 | 5 |
These projections are no more than an educated guess and are used for illustration purposes only. Make your own projections, but understand that unrealistic projections will yield unrealistic results.
Investing for Income
We can now determine how much to allocate to income investments and how much to growth investments.
Take a retired investor whose objective is to earn $60,000 per year (after tax) from investments while protecting capital from inflation.
If he/she earns an average return of 7.0% p.a. on income investments at an average tax rate of 15%, with 2.0% inflation, we arrive at a net return of 3.95% and a required investment of $1.519 million:
| Average return: | 7.00% |
|---|---|
| Less tax at: | 15% |
| After tax: | 5.95% |
| Deduct inflation: | 2.00% |
| Net return: | 3.95% |
| Required income after tax and inflation: | $60,000 |
| Required capital (60,000 x 100/3.95): | $1.519 million |
Adding growth investments
If we recognize hedging against inflation as a long-term goal and not an immediate cash flow need, we can consider funding the inflation element of the portfolio with higher-yielding growth investments.
Income Component
First we calculate the capital required to meet current income needs:
| Average return on income investments: | 7.00% |
|---|---|
| Less tax at: | 15% |
| After tax: | 5.95% |
| Required income after tax: | $60,000 |
| Required income investment: | $1.009 million |
Growth component
Growth investments typically enjoy higher after-tax returns because of improved performance as well as a lower tax component — through capital gains concessions and franking credits on dividends (for Australian investors).
| Average return on growth investments: | 9.00% |
|---|---|
| Less tax at: | 10% |
| After tax: | 8.10% |
| Deduct inflation: | 2.00% |
| Net return: | 6.10% |
| Required income from growth investments ($1.009m x 2.0%): | $20,180 |
| Required growth investment ($20,180 x 100/6.1): | $0.331 million |
| Total required capital: | $1.340 million |
Using growth investments to fund the inflation component reduces required capital to $1.340 million, a reduction of $179,000. Alternatively, if we invest the previously determined capital amount of $1.519 million, we should average close to $11,000 of additional income (after tax and inflation) each year. With higher inflation rates, the difference is even greater.
Remember that this example does not take into consideration your personal needs and circumstances. Also, taxation and investing for retirement are complex subjects and we recommend that you consult a professional adviser before making any decisions.