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By Caroline Ritchie
If you have cash on hand to invest for the longer term, your number-one question might be: where can I get the best return?
Interest rates at banks are at historical lows. Share values are at all-time highs. That sheet of term-deposit offerings is probably wearing a hole in your hand. In this environment, where should you look to make the most of your money?
What’s best for you?
Before you race off to invest in one of the ‘high yield’ options being advertised, take a snapshot. Sure, everyone wants to make the best return, but this means different things to different people.
If you’re 25 and just starting your first serious job, your investing requirements are almost the opposite of those of a couple aged 68 and wishing to lock down some comfort and security.
In your 20s, you will be saving towards the future and should not need to touch that money for a few years. You can afford to take a little more risk and you have time to ride out the markets as they fluctuate.
If you’re newly retired, you are more likely to want to make sure your income stream is stable, and will look for a no-surprises approach to managing your nest-egg.
What ‘returns’ actually means
Quoted returns can be confusing, and it’s important to recognise the difference between ‘income’ and ‘capital’ return.
Income is the earnings that an investment generates from within through interest and/or dividends. It’s different from any changes in the value of the asset itself. These price changes are shifts in ‘capital value’.
Cash in the bank (as savings or term deposits) provides income only. The only return is the interest you receive from the money you invest.
In stable economies, cash doesn’t experience growth or depreciation – that is, it doesn’t vary in value by itself. It increases in value only if you reinvest it and compound the interest you receive – that is, gain income from the original sum you invested, plus the interest it has earned.
Cash returns are typically the lowest. Cash investments are mostly very low-risk, and the stated return is what you’ll actually receive, less tax.
Portfolio returns provide a mixture of income and capital returns.
A typical low-risk portfolio consisting of 30 per cent shares and 70 per cent fixed interest might have a total stated return after fees of 6.5 per cent over the last year. That sounds pretty fantastic for ‘low risk’, especially when cash in the bank is earning only 2.5 per cent. However, it is crucial to understand what that return actually means.
The ‘income’ on the portfolio may have been, say, 3 per cent. This means that the interest paid on the cash and bonds in the portfolio, plus any dividends paid on the shares, equated to 3 per cent of the 6.5 per cent.
The rest of the return (3.5 per cent) came from ‘capital growth’. That means the amount that the share portion of the portfolio increased in value, on paper. And this is the power of portfolios in good times – even though only 30 per cent of your portfolio is in shares, when markets fly, as they have done for the past six years, they can boost your overall return considerably.
Remember, it works the other way around too. In poor stretches, the portfolio, even though it is low-risk, may produce negative returns. Even if the fixed-interest portion is still producing income, if the shares have dropped in value it will affect the overall return.
The key thing to realise with any printed portfolio return is that it is never static. Returns will vary from year to year. The numbers that you read on the reports may not be what you’ll actually receive in the long term. In fact, I guarantee they will not be!
The total return on bonds also varies with both their capital and income components. Typically, though, with quality bonds, the capital shifts are small – certainly less than shares.
Bonds are valued on the market in terms of the yield (income) they currently produce. They are included in portfolios primarily for the income they generate, rather than their capital returns.
Listed property trusts provide investors with a mix of capital and income returns. They have been a popular haven for investors in recent years, due to fairly stable prices and attractive pay-outs.
They trade on the share market like regular stocks and are usually backed by a large and diverse collection of commercial, industrial and retail properties.
Much attention has been focused on particular shares that generate high dividends. On the face of it, these can look tempting. But buying one share only, such as Fletcher Building or Sky Network Television, can leave you exposed to the concentrated fortunes and mishaps of a single company.
So, where are the best returns?
The biggest question asked by clients right now is where to get more income. Depending on your age and stage, you may be able to tolerate more ups and downs to achieve greater returns.
There are still a couple of truisms left in investing – and one of those is “the greater the expected return, the greater the risk”. The total return always reflects the underlying nature of the businesses involved.
Remember too that with listed property trusts and shares, the dividend yield is related to the price. Every time that price changes, the quoted yield does too.
What does the future hold for interest rates?
For the past ten years, long-term interest rates have been trending down. Recent political events in the US have seen these turning around and heading north, albeit in a very small way. We may be at the turning point, but do not expect to see cash rates rocket off back to 8 per cent any time soon.