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Michael Pope Blog post by Michael Pope

The Impact of Growth vs Yield

Growth vs Yield? In whichever kind of investment, this question has always brought along endless debates. In previous newsletters, we have discussed the impact of the capital growth of an investment asset and the yield or income produced by that asset.  In the majority of long term investment strategies, both of these factors are important.  The goal will generally be to develop a passive income stream from the selected investment assets to supplement or replace the income received from paid employment, so the investments need to be delivering an income stream which is both sufficient for our needs, and growing over time (to keep pace with the increasing cost of living).

The total return received from an investment asset will be the combination of its growth in value over time and the yield it delivers along the way.

So which is more important?

Should we focus on assets yielding a high income stream, or assets delivering a high long term average growth in value? Why not both?

Ideally we would like to find assets which deliver both high growth and high yield, but in practice, there will almost always be a trade-off.  All other things being equal, the total return on a given type of investment asset will generally be limited, and so we will need to choose what balance of yield and growth will best suit our investment strategy.

For example, there are a range of managed funds which offer portfolios which allow investors to choose an investment strategy delivering a choice of growth or yield depending on the share selection approach used by the fund.  We can get an idea of how this works by looking at an example of a hypothetical individual company[1].  Let’s assume that the company starts the year with assets worth $1 million, and generates a profit by the end of the year of $150K, or a return of 15% on assets.  The company now has a choice of what to do with those profits – they can distribute them to shareholders in the form of a dividend, or they can retain the profits and reinvest them in the company.

In the case of a 100% distribution of profits as dividend, the shareholders will have received a yield of 15% on the investment, but no growth, as the company is still worth the same as it was at the start of the year.  In the case of retaining 100% of the profits, the shareholder will receive no yield, but, as the company’s assets have increased by $150K, the value of the shareholder’s investment has grown by 15%.  Of course, the company could choose to distribute half of the profits generated, in which case the investor would receive a 7.5% yield on their investment and an increase in value of their investment (capital growth) of 7.5%.

We expect that if the company chooses to retain any or all of the profits, it will reinvest them in the operation of the company, allowing it to generate a correspondingly higher income and therefore profit in the following year, allowing it to maintain a certain level of return on assets.  This level will change from year to year, depending on company, market, national and global economic factors, but in this simple example, we will just assume the company can continue to generate the same 15% return year after year.

So let’s compare a company which distributes one third of its profits and retains the other two thirds (i.e. 5% yield and 10% capital growth) with a company which distributes two thirds of its profits and retains the other third (i.e. 10% yield and 5% capital growth).  The first company could be part of a “high growth” investment strategy while the second could be part of a “high yield” strategy.

After one year, the high growth company would have increased in value by $100K and delivered a yield of $50K for a total return of $150K.  The high yield company would have increased in value by $50K and delivered a yield of $100K for a total return of $150K.  So the investor in the high yield company would have more cash in their hand to fund any costs of the investment, or to spend as they choose.

After 3 years, the high yield investment will have returned a total of $430K compared to the cumulative income from the high growth investment of $232K.  However, the high growth investment is growing in value faster, and so the income stream is also growing faster.  After 10 years, the high yield investment will have returned a total of $1,420K compared to the cumulative income from the high growth investment of $925K.  After about 23 years, the accumulated income from the two investments will be equal, and after 30 years, the high yield investment will have returned a total of $7.0M compared to the cumulative income from the high growth investment of $9.0M.  The numbers show that, for a long term investment strategy, the greater overall return will be achieved by selecting an asset with as high a growth as possible (provided the yield or other cashflow is sufficient to fund any ongoing costs).

And these numbers don’t take into account the increasing value of the investment.  Looking at the total return from each investment after 30 years, comprising the growth in the value of the investment and the accumulated income, the high growth investment will have returned over $25M compared to the return from the high yield investment of just over $10M.

So in developing an investment strategy and selecting investment assets, the choice between growth and yield is going to have a major impact on the outcome achieved.

This is why the combination of yield and growth rate are critical factors in the success of a long term wealth creation strategy, and why Empower Wealth considers the choice of investment asset to be such an important decision in implementing an investment strategy.

Empower Wealth’s Property Portfolio Plan includes a sophisticated Wealth Projection Simulator which allows you to see the effect of asset selection decisions by modelling the effect of different yields and compound growth rates, together with all the other factors which influence the long term financial outcome of an investment, to give you the numbers you need to make an informed decision about your financial future.

If you would be interested in seeing how these tools and techniques could be applied to your own personal financial situation, please come and see us for a free one hour consultation by registering at our website or just give us a call.

[1] These simplistic examples ignore the effect of taxation, and don’t consider the effect of reinvestment of accumulated profits.

 

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