The goal for most investors is to accumulate enough wealth so their investment assets generate sufficient passive income to meet living expenses.
If this happens, it is no longer necessary for you to work for an income and you then have complete discretion over what you do with your time.
Wouldn’t that be wonderful!
However, an error that many investors make is that they invest for income when they begin their investment journey.
This is a slow and very inefficient way to achieve financial freedom.
Using a golfing analogy, it’s akin to teeing off with a putter – you will probably get to the green eventually however it will take you too many shots.
Instead, a more efficient way to build wealth is to do it in two steps.
Firstly, you need to build your asset base.
Then, when you have a strong asset base, you can tilt your asset allocation towards income.
It’s easy to develop a retirement strategy for someone with a net worth of $4 million (invest it in cash at 3% p.a. will generate $120k p.a.).
It’s a lot harder to do it for someone with $400k.
The make-up of the total return is important
The problem with investing for income initially is you lose a lot of your return each year in tax.
If an investment pays me $10,000 in income, I’ll probably pay $4,000 in tax and have $6,000 leftover to reinvest.
Whereas, with capital growth, you don’t pay tax until the investment is sold so you get to reinvest the full $10,000.
The chart below demonstrates the impact of tax on two investments that provide the same total return of 10% p.a. – option 1 has more income and option 2 has less income.
Comparison… more growth versus less income
Many people that consider investing in either shares or property are unsure how to compare the two.
Assuming you adopt the right strategy, I think it’s reasonable to expect comparable overall returns from either shares or property.
However, the difference is the amount of income.
Property will typically provide 30% of its overall return in income (e.g. 3% income and 7% capital growth) whereas, with shares, it’s likely to be 50/50.
For example, this ASX200 index fund has delivered a total return of 8.78% p.a. over the past 5 years.
The current income yield is 4.44% p.a. meaning just over 50% of the total return has income.
Quite the reverse.
I believe that we must diversify amongst various asset classes because no one can predict which asset class will perform the best in the short run.
Therefore, if you spread your wealth across various asset classes, some will win, some will lose but in the long run, you’ll smooth your return and do very well.
In that regard, shares play an important role:
- It’s great to have shares/equities exposure inside super to minimise the tax on the income return (or even eliminate it with imputation credits); and
- You should consider investing in shares after you have acquired the necessary amount of property investments. It is important to do this in the right order for tax and wealth efficiency.
Shares and bonds play an important role in most investment strategies but it's nearly always important, to begin with property.
If you need to build your asset base
If you don’t have a strong enough asset base to comfortably achieve your financial and lifestyle goals, then you need to invest in assets that provide most of their overall return in capital growth.
These assets need to be of investment-grade quality.
Borrowing to purchase such assets is a very effective strategy as it forces you to invest more money sooner and it's tax effective (of course do it safely).
There are many things to consider when developing an investment strategy and the income/capital split is only one of them so please seek personalised advice before making any decisions.
Editor's note: This blog was originally published in July 2018 and has been republished for the benefit of our many new subscribers as the
information is just as relevant today as it was then.
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