With uncertainty surrounding where interest rates are headed investors are now questioning their investment approach and revisiting the age-old debate – Should I be striving for the best capital growth or the highest investment yields?
You may have heard from a friend… “It’s a great investment, the returns are higher than the holding costs!” On the face of it, this may sound enticing, but it doesn’t guarantee a great investment selection.
The shortfall of many yield-focused investments is the false sense of achievement it can give an investor when measured over the short term.
Investing is about achieving profitable returns and the overall return on investment is made up of both yield and capital growth, this is why most investors are really asking:
How can I make investments decisions that achieve the most profitable returns?
It is a question I’ve been asked consistently throughout my 20 years in financial advice. Structuring investments to achieve a four-fold return – that being income returns, capital growth, tax savings, and interest savings – is where significant investment performance can be achieved.
Before focusing on investment structure, it is important to understand the role yield and capital growth play when choosing an investment.
Impact of Yield vs. Capital Growth on Investments
The following graph shows the actual yields for a $100,000 investment in both cash and shares over the last 30 years.
Observation #1 – In the first five years the interest paid on Cash outperformed the dividend earned on shares.
Observation #2 – As the decades passed the annual income return on shares convincingly outperformed cash.
Observation #3 – In the final year ending 2012 interest paid on cash is $5,200 and dividend paid on the shares is $42,000
At this point you may be forgiven for thinking that your share investments have the higher yield, but this is not the case.
Let’s see what happens when we overlay the capital values for a $100,000 investment in both cash and shares from 1983…
Observation #1 – Not only have our dividends risen to approximately $42,000 per annum but the capital value of our shares have also risen from $100,000 to $910,000. Clearly this is a good result for the share investor. However…
Observation #2 – Because the capital value of our shares has also risen, being the denominator in our yield equation, it has dragged down the net yield for that year, ie. 42,000 ÷ 910,000 = 4.6%.
Observation #3 – Because the capital value of the cash has remained constant at $100,000, the yield calculation for Cash in 2012 is 5,200 ÷100,000 = 5.2%.
So technically our cash investments are still paying the higher yield.
Highlighting the importance of focusing on the long-term characteristics of your investments and not simply the yield…
Yield is an important contributor in a balanced investment plan
The importance of yield when investing
Investment yield will pay us an income stream that we may rely on in order to live or to meet the holding costs of our investment. When we’re in our wealth accumulation years many of us will employ gearing strategies – meaning we will borrow money to invest. If this is the case then yield is very important in meeting the borrowing costs and any other out-of-pocket expenses incurred in holding the investment.
If the yield is not reliable, we may be forced to sell the investment before it has had a chance to mature, or experience any capital growth. If this is the case, it is quite probable that our overall financial position has gone backwards.
Yield plays an important role in meeting the holding costs of an investment.
The importance of capital growth when investing
Once I am satisfied that I can meet my holding costs despite possible fluctuations in yield, my primary concern will be the capital growth of my investment.
The following table shows why this is the case:
Investment A has a yield of 10% and growth of 5%
Investment B has a yield of 5% and growth of 10%
Observation #1 – By year 20 the yield of investment B being $1,431,875 has almost caught up to the 10% yield on investment A being $1,653,298. You can see that the yield of each is based on the annual increasing growth amounts.
Observation #2 – In addition, 5% growth on investment A has grown to $826,649 compared to 10% growth on investment B which is now $2,863,750.
Observation #3 – In total, investment B has a cumulative return of $1,815,678 more than investment A.
Investment Yield or Growth: Takeaways
- Focusing on the long-term characteristics of your investments can result in significant performance differences
- Yield plays an important role in meeting the holding costs of your investments.
- If you are in a financial position to meet the holding costs of the investment, finding an investment with strong capital growth potential should be your long-term goal.
- Most investments exist on the spectrum of somewhere between high growth and low yield or low growth and high yield. You need to find the right balance for your current financial position.
- Investment decisions should be made in consideration of your entire financial and personal circumstances.
Making the most of your investments
A well-structured Wealth Plan considers your investment options in addition to the many strategic opportunities available for achieving savings in tax, bank interest, product fees, professional fees, and risk. The correct structure combined with the right investment selection can significantly impact investment performance.
Considering an investment or curious about personal investment structures?
A short phone call is all it takes to determine if our advice will be of value to your financial position.