Capital Growth and Income – How does it all work?

Author: Ryan O’Grady, Financial Planner at Navigate Financial Group

Capital Growth

What is it?

Capital Growth is simply the increased value of an owned asset over its original purchase price.  Two of the most common examples of assets in Australia that experience capital growth are property and shares. For an asset to increase in value in a market environment, according to economic theory, there must be either increased demand or reduced supply of the asset for this price increase  to occur.

Risk versus Return

When you invest, it is generally expected that the more risk you take, the greater the potential for returns however with the increased risk, there’s a greater chance of losing some or all of your capital.

With taking a lower risk approach, your investments are less likely to achieve high capital growth but are also less likely to lose capital value. This is very important to understand when investing to ensure that you are only taking risks that you feel comfortable with or that best meet your goals you are trying to achieve.

Income

What is it?

Investment income is simply the revenue generated from an asset. This income can come in many forms  including:  Interest payments on cash or bonds, dividends from shares, rent from property and distribution of earning from managed funds to name a few.

Interest Payments

Generally interest is paid on capital that you choose to lend for duration of time. These are usually in the form of cash and bonds. The amount of interest payable is usually based on the duration of time that you “lend” your money as well as the national cash rate determined by a central bank (The Reserve Bank in Australia)

Dividends

When a company makes a profit it can choose to either retain some of it for future expansion or it can make a dividend payment to shareholders. A dividend is a portion of a company’s profit that it decides to pay out to shareholders, in return for their investment. (CBA, My Wealth Learn)

Managed Funds Distributions

Managed funds earn income in the form of dividends, interest and realised capital gains, that is, the profit made from selling an investment that has increased in value from the date of purchase. The fund manager is obligated by law to pay out this income to investors in the form of distributions.

The frequency of distributions varies from annual, semi-annual to quarterly depending on the fund. This information can be found in the fund’s product disclosure statement. Distributions are most often paid in June and December. (Morningstar)

So which is best?

This is one of the most commonly asked questions I get asked by clients. I usually respond to it with a question of my own:  “What are you trying to achieve with your portfolio?

Many retirees are simply trying to generate an income to live off while a young couple in their early 30’s may be much more growth orientated.  What is very important to remember with investing is the overall, net return on an asset over time.

Many Australians (especially pre retirees and retirees) fall into the common category of Asset Rich, Cash Poor. They have accumulated assets through capital growth during their working lives and all of sudden find that when their income from working stops, their investment income is not adequate to fund their day to day lives and may have to start selling down on growth assets to move to those that produce more income.

Assets that experience high capital growth will generally tend to have a lower yield (income) and the same can be said for higher income assets having less capital growth. (Graham, B., The Intelligent Investor) During certain economic conditions , having the correct asset allocation can be crucial to improving overall returns of a portfolio and should be reviewed regularly.

Key points to consider:

Tax

Not only do you need to pay tax on investment income but you may also be liable for capital gains tax when disposing of an asset.

Some assets have tax advantages such as dividend franking and deductions associated with borrowings.

It is important to factor in all taxation of an investment to calculate the actual net returns on the investment. This is a common fault amongst new or less experienced investors who simply look at the gross returns on an asset.

Reinvesting Income

Einstein has been quoted with saying “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” If your goal is maximise your savings over a long investment timeframe, then reinvesting your income makes perfect sense.

Again, before deciding on whether to re-invest or draw income, it is important to understand your goals, what it is that you are trying to achieve with your savings and at what stage of life you may be at.

Diversification

When constructing any investment portfolio, it is important to diversify appropriately to help reduce risk. The weighting toward income producing assets (which generally the most capital stability) can suit those with a lower appetite for risk while those who are happy to experience a little more volatility in their capital may choose growth orientated assets . As always, please ensure that you have a  full understanding of an assets risk before investing or contact your financial planner for further information.

Ryan O’Grady

Financial Planner

Authorised Representative, AMP Financial Planning

Navigate Financial Group Pty Ltd (ACN 128 056 002), is an authorised representative and credit representative of AMP Financial Planning Pty Limited, Australian Financial Services Licensee and Australian Credit Licensee

‘This article contains information that is general in nature. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs before making any decisions based on this information. If you decide to purchase or vary a financial product, your financial adviser, AMP Financial Planning Pty Limited and other companies within the AMP Group may receive fees and other benefits. The fees will be a dollar amount and/or a percentage of either the premium you pay or the value of your investment. Please contact us if you want more information.’

References

  1. http://www.morningstar.com.au/funds/article/understanding-your-fund/4543?q=printme
  2. https://www.mywealth.commbank.c om.au/learn/investing-basics/what-are-dividends
  3. Graham, Benjamin; Jason Zweig (2003-07-08) [1949].The Intelligent Investor. Warren Buffett (collaborator) (2003 ed.). HarperCollins. p. vii
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