If you had, or have, £250,000 in cash and wanted to invest it in a way that would provide you with a cash income without eating into the original investment capital, how would you go about it? It’s a far from unusual question, particularly if the sum in question is not exactly £250,000 but any significant lump of capital to be invested with a view to generating a regular income stream.
And even for investors starting out with a much smaller lump sum or regular contributions to an investment portfolio, investing for income is important. Because over the long term, it is reinvesting income generated by investments back into more investments that makes a huge difference in growing the value of a portfolio. But not all kinds of common investments generate income. That doesn’t mean they don’t generate returns for investors but in a different way. Understanding the distinction is important. Especially for investors whose investment goal is for their invested capital to generate regular cash returns.
Two Different Kinds Of Investment Returns –Income Generation vs. Capital Gains
Investments are made on the principal of an investor taking on some level of risk with a view to eventually getting back more money than they put in. That’s usually achieved by investment capital funding usually a company, sometimes a national government and occasionally another kind of organisation.
The recipient of the investment capital then invests that money in expanding or improving their business or operations in a way that helps them generate more money. In return for providing that funding, the investor either receives an ownership share in the company in the form of shares, referred to as an equity investment, or an interest rate. The latter is a debt investment and isn’t dissimilar to the principal of bank loan with the investor replacing a bank as the source of capital.
Debt investments are almost always income investments because the return on investment is the interest rate the borrower agrees to pay on the capital provided by the investor. That interest rate is paid in regular instalments, usually annually, bi-annually or quarterly. And the original capital sum invested is also returned to the investor at the end of the agreed period. The investor gets back the same amount of money they originally invested. But in the meanwhile the investment earned an income in the form of the regular interest rate payments.
Share in companies that pay regular dividends, a portion of profits generated divided among all shareholders relative to their ownership stake in the company, are another kind of income investment. Even if the share price doesn’t grow in value, the investor benefits from a regular share of the company’s profits so makes a return on investment without having to sell the shares at a higher price to that which they bought them at.
There are other examples of income generating investments and we’ll cover the most common forms, as well as looking at bonds and dividend-paying shares in more detail, a little later.
But not all investments give out a regular income like bonds and dividend-paying stocks. In fact, many of the most popular stocks and other investment classes in the world either offer modest and irregular income or none at all. Apple, for example, is the only ‘FAANG’ stock so far to pay out regular cash dividends and the five huge technology stocks that make up the group – Facebook, Apple, Amazon, Netflix and Google (Alphabet) – have been the most consistently invested in stocks in the world over much of the past decade.
Investors in the FAANGs and other companies that don’t pay out dividends are motivated by another form of hoped for return – capital growth. Many of the biggest tech and other ‘growth’ companies have a policy of retaining all of their profits to fund the capture of a larger market share for their core business or to move into new sectors. Google-parent Alphabet and ecommerce giant Amazon are the most well-known examples of growth stocks. Both earn huge profits and are sitting on cash piles worth more than some national economies. But choose to retain their income to fund aggressive expansion and new products and services.
More than a few big names, most notably Uber, even operate at a significant loss and rely on new share issues or raising debt to survive. But they still attract significant numbers of investors. But why would investors put their money into loss making assets or those that don’t pay them back a share of profits? They are betting on the growing market share and revenues of such companies leading to share price growth. It’s a bet on the future profit generation potential of those companies. To earn a return on investment before that moment the investor relies on new investors being willing to pay more for their shares than they did.
Whilst the most common kind of capital growth-targeted investment for retail investors, growth shares that don’t pay dividends are not the only kind. Other examples of investment classes that target capital gains would be commodities or currency (forex) trading, alternative investments such as collectibles and certain kinds of land banking.
In summary, as concisely defined in The Balance:
“Growth stocks are securities of companies that have potential to grow their earnings faster than the average company. Income stocks are those that pay above-average dividends. Bonds, which are included in the broader fixed income category, are inherently income securities because they pay interest to the investor”.
Is It Better To Invest For Income or Growth?
A natural question to ask is if income or growth investments ultimately deliver superior returns? Unfortunately, there’s no definitive answer to that question. Research analyst John Dowdee has conducted research published in Seeking Alpha that broke stocks down into six categories and studied the risk to return ratio between the categories. The six categories were small, mid and large cap income stocks and small, mid and large cap growth stocks. The study concluded that between the years 2000 and 2013, all three categories (small, mid and large cap) of income stocks outperformed their growth counterparts.
However, over shorter periods this was not the case. From 2007 to 2013 growth stocks outperformed. Growth stocks have also, over the entirety of the last decade, significantly outperformed income stocks. The conclusion that Dowdee came to was that income stocks outperform over long periods but growth assets can do better short term.
There have been many other studies on the growth or income question looking at different periods of time. Another, by Craig Israelsen, looked at the performance of growth and income companies across the three cap sizes over the 25-year period between 1990 and 2015. The conclusion was large cap income stocks outperformed large cap growth stocks by an annual average of 0.75% over the period.
For medium and small caps, the outperformance of income stocks was even more pronounced. However, the research also showed that over any given 5 year period, large cap growth and income stocks were almost evenly split for outperformance. But when growth stocks did prevail the difference was often much larger. However, small-cap value beat growth almost 90% of the time over rolling 10-year periods, and mid-cap value also beat its growth counterpart.
The bottom line is that what the best choice might be boils down to investment goals, timescale and appetite for risk. Growth investments can deliver much stronger returns than income investments over shorter periods of time but are also more vulnerable to volatility and sharp falls in value when markets fall. Asset ‘bubbles’ and market crashes tend to be catalysed by growth investments that have grown ‘too much’.
Growth assets tend to perform strongly during bull markets but suffer much more than income-generating assets during bear markets. Most financial advisers suggest balancing a portfolio between growth and income assets with riskier growth assets earlier in the portfolio’s lifetime and the balance gradually moved in favour of income investing assets as time goes on and moves closer to time the investment portfolio is intended to start providing a cash income.
Pure Income Investing Most Common As Capital Preservation Approach
An investor asking the question of how to invest £250k for income may well have cashed the sum out of riskier growth assets and now wants to generate cash flow while preserving capital value. Or, the £250,000 could be allocated to income generation as part of a broader investment portfolio, with the remainder more capital growth focused.
There are a number of different income investment vehicles which offer varying degrees of risk and other qualities. With £250k to spread around, the best approach is, like any investment portfolio, most likely to be splitting the investment between a number of them. The exact balance will depend on investment goals and risk appetite and tolerance.
Income funds are the most obvious and accessible income investment vehicle. These are actively managed funds that invest in income-generating assets such as dividend paying stocks, REITs and bonds. Income funds can focus on one particular income asset, such as equities or bonds, or combine them. They also come with different risk profiles.
Investors could also pick their own dividend-paying stocks if they feel confident in their ability to do so wisely and are willing to commit the time to then monitoring the portfolio and adjusting periodically as necessary. The same can be said of bonds, which range from those which are very secure but offer a modest payout, like UK government Gilts, US Treasuries and investment grade corporate bonds to ‘junk bonds’, which are issued by companies and tend to pay a much higher ‘coupon’ or interest rate but also carry a higher risk of default.
Further still along the risk to reward access are a kind of bonds called ‘mini bonds’. These are typically offered by quickly growing but still relatively immature businesses and can offer very good returns. But the nature of the kind of companies that usually issue mini bonds, young and high growth with a lot of potential but no long track record or significant cash buffer, means they are high risk.
Like any investment portfolio, an investor can spread an income investing portfolio across income generating assets of different risk profiles to create a sensible balance in line with their personal investment targets and preferences.