Don’t just invest for income – it’s total return that matters

In this series we are looking at the issues surrounding investing for income and how it can be used to increase the money you have to spend or grow your wealth.

In the first part James Norton, senior investment planner at Vanguard, looked at the basics of dividends, bonds and interest. 

In this instalment, he explores the different sources of income you may have, the distinction between investment income that helps to build your savings, and the income you receive in retirement.

Gains made from investment portfolios serve as an integral part of your income at retirement 

Why it’s not just about income – growth matters too

The traditional route many investors have taken when managing a portfolio for income has been to buy a number of UK equity income funds and balance this with some fixed interest bonds funds to reduce the risk and top the income up.

The idea being that the income from these combined investments could then be spent and the investments would be left to grow.

However, this is the wrong approach for most people. In fact, despite the title of this series, the whole concept of investing for income is flawed. Here’s why.

Assume Bob has a portfolio of £250,000 and he needs income of £12,500 a year, which works out at 5 per cent of his portfolio value. 

Should he care about how he gets that? Does it matter if all of it comes from income, capital growth or a combination of the two?

Provided the portfolio generates the required return of 5 per cent he should be happy. In fact, given that capital gains receive a more favourable tax treatment than income, there’s an even stronger argument not to focus on income. 

The crucial thing is that the portfolio generates a sufficient total return, the combination of income and capital growth, so that Bob does not run out of money. 

Why are we so fixed on income? 

Why are so many of us fixated on income? 

The reason is simple. When we come to retire, most people find it very hard to contemplate spending capital. 

When we retire, we are faced with the fact that we’re not earning money any more, just spending it. And that causes a capital-preservation instinct to kick in. We can no longer make the losses back through earned income. 

The result is an unhealthy fixation on making sure the portfolio generates a high income so we don’t have to touch the capital.

So, while income is an important part of the overall return a portfolio generates, we should not be fixated on income. 

We all need money to spend in retirement, but our primary concern should be the total return our portfolio produces, not the income it generates.

In the earlier example, what use would an income of 5 per cent have been to Bob, if the portfolio’s value fell by 6 per cent?

Next time: In part 3 we are going to look more at the risks of chasing yield and some common traps that investors fall into.