An important component of a sound lifelong investment strategy – the Art and Science of Investing as we call it – relates to total return versus income investing.
Historically, investors holding a diversified portfolio of shares and bonds could quite easily generate a healthy income from their investments. Not anymore. With yields on low-risk government bonds at historic lows and likely to stay that way, how can the income conundrum be addressed?
There are three basic options for investors whose portfolio income falls short of their spending plans: they can spend less; they can reallocate their portfolios towards higher-yielding investments; or they can spend from the total return of their portfolio, which includes capital appreciation as well as income.
For many investors, moving away from a broadly diversified portfolio may place their investments at greater capital risk than actually spending from capital.
For example, four common approaches to boost portfolio income are to:
1. Increase weightings to longer-duration bonds;
2. Invest in higher-yielding, credit-sensitive bonds;
3. Allocate some of the bond weighting to income-generating shares; or
4. Allocate some of the broad share weighting to higher dividend yielding shares.
Each of these approaches carries its own potential dangers. Longer-duration bonds, for instance, are typically more susceptible to capital losses when interest rates rise. Meanwhile, higher-yielding bonds carry greater credit risk than government bonds and can exhibit high levels of price volatility in times of market stress, greatly reducing the diversification benefits of holding fixed income alongside shares.
The third option, moving some of the bond portfolio to high-yielding shares, can substantially alter the risk profile of the portfolio, potentially exposing investors to much higher levels of capital risk than those set out in the original plan. Finally, moving some of the broad share exposure into higher dividend yielding shares could skew the portfolio towards certain income-generating sectors, reducing diversification and potentially increasing risk.
Think total return
Rather than pursuing any of these four paths, Fort Financial Planning favours a total-return approach, i.e. one that focuses on both income and capital appreciation. Such an approach has the advantages of maintaining the originally agreed-upon asset allocation and controlling risk by ensuring maximum diversification.
The amount of value that can be added by employing a tax-efficient total-return strategy will vary according to the size and breakdown of portfolio and the spending needs of an individual. However, it is likely to be significant for many clients, especially when due consideration is given to the other key components of a sound lifelong investment strategy.