Getting the Income and Growth Split Right

Traditionally it was normal to work out how much tolerance to risk an investor had, and then invest the appropriate mix of growth assets and income assets.  Retirees normally required income to supplement their pensions, and young people wanted growth as they had sufficient income.  The majority of returns from growth assets came from growth, and the majority of returns from income assets came from income.  Growth assets were regarded as being risky, whereas income assets were regarded as safe.

Then the reality set in.  Assets such as finance company debentures and CDO based funds were sold for income purposes as were property syndicates.  They were hardly safe investments.

Some assets do not fit nicely into the income versus growth split.  Property produces most of its long term returns from income, yet is often regarded as a growth asset.  Are infrastructure shares income or growth assets? Infrastructure normally has a predictable income stream, and there are often profit constraints imposed by regulators.

Corporate bonds are primarily sold for income purposes; however the capital value can be almost as volatile as a share.  With dividend yields typically being close to corporate bond yields, why not benefit from a growth booster through owning the head share.  The risk is often similar.  If the corporate bond cannot meet its coupon payment, the bond will become almost as worthless as the head share price, as it will have invariably fallen to penny awful status.

What investors need are high returns and a level of risk that they can cope with.  The choice of it coming via income or growth should be a secondary consideration.  This means that perhaps we should classify assets as being defensive or risky.  Some high income producing assets are defensive and some are risky.  Some growth assets will prove to be defensive but most are risky.

The key issue is how much of a portfolio should be in risky assets.  We also need to think of risk in terms of short term volatility and the chance of long term poor returns.  In Australia, hundreds of millions of dollars were invested into forestry schemes.  The returns were to be enhanced by taxation concessions.  Most of these investments have now been written off.  This was an example of what was sold as a low risk investment.  Undoubtedly some of the numerous forestry investments that were sold to retail investors in this country will not provide anywhere near the forecast returns. 

Few investors in New Zealand property syndicates over the past fifteen or so years have had an enjoyable experience.  Returns for the first few years were invariably very predictable.  Over time the market changes and property revaluations tend to be downwards as overall lease durations shorten.  Few property syndicates are really actively managed.  After all if the property really increased in value, wouldn’t it make sense to sell the property and bank the profits? Well, it should, but there would be all the depreciation etc to repay.  Also, the manager would no longer have the property to manage and charge management fees on. 

If you no longer want to own the property syndicate, what do you do? You try and sell it on the secondary market and invariably discover that there are only buyers at around 50% of the price shown on a valuation report.  So the investment that was sold as providing solid low risk income returns often proves to be a real dud.