Secondary

Income – consider the risk/return trade-off

Investors looking for income should consider the risk/return trade-off.

All investments aim to generate a return, but there is a corresponding level of risk that impacts the return. Many investors rely on being able to draw an income from their capital lump sum, whether immediately or for a potential future income. John Kinsley, MD of Unit Trusts at Prudential Portfolio Managers, explains the risk/returns trade-off between a stable and ‘secure’ income from cash instruments versus income that keeps pace with inflation from income-generating funds. In these trying times, considering this trade-off is essential to making the right investment decisions for a rewarding investment regime.

Cash is king for investors who wish to draw immediate income, and who want minimal risk

‘Cash investments, investments on the short-term money market, are useful if you need money quickly as it can be accessed easily,’ explains Kinsley. This asset class holds minimal risk, but also provides a low return. Consequently, the returns may not beat inflation, which poses a risk to the purchasing power of investors’ money,’ Kinsley warns.

Fixed-interest investments are longer-term loans than cash and consequently the interest earned on this kind of investment will be higher than that of cash. ‘Fixed-interest investments pay a steady return and can be cashed in quite easily,’ says Kinsley. In terms of risk, investors should keep in mind that loans to companies are generally riskier than loans to governments.

Prudential manages a range of low-risk income-generating funds, from their Money Market Fund to low-risk balanced funds.

Property is a good option for both a continuous income flow and future income injections

Property generally offers a higher income than cash or fixed-interest investments. ‘Property is a useful asset because the rental payments will provide a steady income and there’s potential for capital growth,’ says Kinsley.

When it comes to property, investing as an individual versus pooling money with other investors and investing in a property fund, will impact investors’ income. Kinsley explains that buying and selling property can be expensive, and there are many costs to consider. On the other hand, many property funds are listed and can be traded, making it much easier to sell them for cash should the investor need an income.

Property investments however hold more risk than cash and fixed-interest investments. Says Kinsley: ‘If the property is not let, no rent is paid, which will affect the flow of income. The value of properties can also fall dramatically, especially in the short term.’

Investors who want to earn a potentially high income and are risk tolerant can consider shares

Most share investments are in companies listed on the stock market, which means it’s easy (and cheaper than property) to cash in shares when investors need an income. Kinsley also emphasises the income-generating advantages of shares: ‘Dividends – a share of the company’s profits – are paid to shareholders, and there is potential for capital growth that is in excess of inflation.’

Before investors are blind sighted by promising returns, they should however keep in mind that the potentially higher returns are offset by high risk levels. ‘Dividends cannot be guaranteed as they depend on the profitability of the company,’ Kinsley explains. ‘Share prices can also fall just as spectacularly as they can rise.’ For long-term investors who want to generate potential income, the frequent outperformance of share investments in comparison to other asset classes is however a strong argument in favour of investing in shares.

Returns from dividend income type funds are taxable from 1 April 2012

In his 2011 Budget Speech, the Minister of Finance outlined his intention to introduce measures that will make the returns from dividend income type funds taxable. ‘Despite this change there remain very attractive alternatives’ say Kinsley. ‘These include enhanced income type funds which maximise income potential across a range of asset classes whilst also managing potential risk very actively. In many cases the after tax return on these funds may be even better than that of dividend income type funds.’

 

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