Invest for income and the capital will take care of itself

Although capital growth receives a great deal of investor attention, investing is ultimately all about income. Retired investors invest to generate an income stream. Pre-retirement investors invest to provide for their future income needs. Investors th

Investing for current income

An investment portfolio providing for current income needs, such as a living annuity, should ideally provide this income without eroding capital. Capital erosion occurs when an investor draws more income than the income produced by the investments. By eroding capital an investor reduces future income, so it is vital in the early stages of retirement that capital is preserved as far as possible. Capital preservation can be achieved by selecting investments that produce the desired income yield.

Constructing a portfolio for current income involves determining the required income level and then acquiring a blend of cash, bonds, real estate and equities which will generate the required income – cash, bonds and real estate providing a reliable high income – equities, enabling the income to grow. Crucially, the choice of equities should include only those which generate a reliable, growing income stream.

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Investing for future income

Where income is not an immediate need, investment decisions are driven by a need to maximize investment value upon retirement. This can be achieved by:

1. Capital accumulation

When income is not required to fund a lifestyle it is reinvested. Reinvesting income will increase an investor’s capital base which will in turn produce more income to reinvest. This accumulation of capital will increase the value of an investment over time.

2. Capital value growth

The value of a company grows over time at the rate at which its profits grows. In the same way, the value of an investment grows over time at the rate at which its income grows. This relationship is clearly evident when looking at the dividend and price history of Mr Price in the chart below.
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To summarise, investment value growth is driven by income – the drivers being income yield and income growth. The more reliable the income produced, the more predictable the end result.

Constructing a portfolio for future income involves determining an investor’s risk tolerance and recognizing that investment risk lies with income growth. Unlike income yield, which is known at the time of investment, income growth is less predictable. Therefore, capital accumulation by re-investing income is a more certain and predictable way of increasing the value of an investment. Over the longer term, however, capital value growth resulting from income growth will generally produce a greater increase in investment value.

Adopting a balanced approach

By combining high yielding investments (i.e. bonds) with investments that have the ability to grow their income (i.e. equities) it is possible for an investor to attain a reasonable level of income with inflation hedged income and capital growth. The income can be used to fund a lifestyle or can be reinvested to accumulate more capital.

Although capital growth receives a great deal of investor attention, investing is ultimately all about income. Marriott’s advice for investors, focus on income and let the capital take care of itself.