I am often asked by prospective clients: What investment returns can I get? Unfortunately, it is not possible to quote a fixed rate for investments returns (unlike cash held in a bank or building society account). Investment returns just don’t work like that.
Investment returns can be both positive and negative. After all the value of investments can fall as well as rise. However, the long-term investor gets rewarded (with investment returns) for taking (and coping with) the short-term risks associated with investing in assets that fluctuate in value.
A prospective client asked about investment returns:
To help me with my decision, could you tell me what range of investment return you guys could get me if I invested £1m with medium risk? I’m obviously looking for a mix between long term growth and an annual income, so growth that not only covered off inflation but delivered income without eating into the capital. What realistically do you feel you could return as an income each year for the £1m?
It is just going to help me benchmark the options available to me.
Here’s my reply about potential investment returns:
Good evening XXXXXXXX
We use a “total-return” approach to investing. This utilises both investment returns and investment income over the long-term. Both sources of “return” can be used for ongoing income. We adopt this approach for two reasons:
Firstly, dividends from investments can be variable. We cannot control whether the directors of a firm will declare a dividend. Targeting higher yielding shares may exacerbate this. Directors of these, higher risk companies need to offer a higher return to attract capital investment. They represent a higher risk and investors will need to be rewarded (risk and return are related). The increased risk may result in no dividend being declared – or worse – the company going under.
Also, since a dividend payment comes from a companies’ bank account, prior to payment the dividend will form part of the companies’ valuation – and will be reflected in its share price. If this cash is paid out (as a dividend) then the value of the company will decrease by the same amount i.e. share price goes down.
Secondly, investing in high yielding fixed income* doesn’t solve the problem either. There are two important factors that impact fixed income returns:
- Credit rating of issuer. This is a measure of how likely the bond issuer is to not meet its liabilities of regular payments throughout the term and/or repayment of the original amount at the end of the bond.
- The duration of the bond until maturity. A longer duration introduces uncertainty around rates of interest and inflation. Regular payments may not match future returns on cash if interest rates rise. The purchasing power of the original capital can be eroded by inflation over timer.
Exposure to one (or both) of these factors will increase the return but will be accompanied by higher risks.
*fixed income investments are fixed term loans to a company (corporate bonds) or government (gilts) with a fixed rate of return, fixed duration and payment schedule set at outset. The original loan amount is returned at the end of the fixed term.
A total-return approach to investing tries to avoid using either of these approaches in isolation. If you think it through, there are essentially three variables that determine the total-return of an investment:
- Interest or dividends paid out or reinvested along the way
- The change (increase or decrease) in underlying share value: how much you paid per share versus how much those shares are now worth
- The impact of taxes and other expenses on these returns
Instead of seeking to maximise interest or dividend income or focus solely on capital growth, total-return investing looks for the best balance of both, whilst reducing taxes and other expenses (which can be significant) – and applying all three to your unique circumstances.
To address the question of investment return I’ll provide a bit of background information on our approach to investments. It is our view that the capital markets work – and work efficiently. They will typically reward investors for being disciplined in the long-term. In the short-term, volatility can force many investors panic sell (or buy) at the wrong time. We encourage our clients to adopt a “buy and hold” strategy and avoid the mistakes of most investors:
- Buying high, selling low (panic selling, following the crowd)
- Trading too often (chasing hot stocks)
- Not being sufficiently diversified (too many eggs in one basket)
Although scary over the short term, the markets will reward a disciplined, buy and hold investment approach over the long-term. In order to deal with short-term volatility, we mix equities (higher long-term returns but short-term volatility) with low-yielding fixed income (reduced short-term volatility but lower long-term returns). This mix of equity and fixed income is the only thing within our (you and us) control. It will determine your portfolio risk and therefore impact your investment return.
We can estimate the expected rate of return of a portfolio based on its long-term average return. However, the return will rarely (if ever) match that rate in any given year.
The chart (below) shows a portfolio with 60% equities and 40% fixed income portfolio. The average return of this portfolio since 1956 has been 11.1% per annum. It hasn’t delivered this return consistently each year. The return has fluctuated wildly year-on-year. In fact, the only year where return was close to the long-term average (orange line) was 1997 (11.3%). In every other year the annual return was either higher or lower than the long-term average. Yet the long-term return has been 11.1% per annum.
This explains why I am unable to tell you what level of income or rate of return you can get.
We work with all our clients to ensure their assets are enabling them to live the life they want. We do not make predictions about the returns of the markets – and I would be wary of anyone who does!
Happy to chat this through or answer any additional questions.
This reply explains why it is impossible for me to answer the questions: “what investment return can I expect?” or “what level of income can I get?”