When income returns are not good

Striving to achieve returns during your working life could expose your portfolio to higher risk

Equity, bonds and real estate can provide income returns and capital appreciation. It is common sense to invest in assets that provide both sources of returns. But should you?

Gains vs income

In your working years, you may save for your retirement or for funding your children’s education. If your daughter were to enter college 10 years hence, while you would want to accumulate enough money, you do not want income returns from your investments. Why?

For one, cash flows during the 10-year period have to be reinvested till your daughter enters college. For another, you may be tempted to consume these cash flows!

But why not collect income returns if an asset provides such cash flows in addition to capital appreciation? The point is: As a working executive, your goal-based investment is an accumulation portfolio that typically contains equity and bonds. If you strive to achieve returns from both sources, you could expose your investment portfolio to higher risk.

Consider bonds. To provide both income returns and capital appreciation, you must invest in gilt funds. You may be able to earn income returns, which a gilt fund may distribute in the form of dividends (includes both interest plus realised capital appreciation). However, bond funds are marked-to-market through their net asset value. Bond fund’s NAV will decline if the market expects interest rate to move up.

On the other hand, you could invest in a cumulative bank fixed deposit, where the maturity value contains accumulated interest compounded over the time horizon for the deposit. So, there is no reinvestment risk. But you do not generate capital appreciation.

Equity exposes you to price risk, whether you aim to additionally generate income returns or not! So, it may seem logical to collect income returns as well. Suppose your portfolio has to generate post-tax compounded annual return of 9.5 per cent for you to accumulate the wealth required to achieve a life goal.

The 9.5 per cent return includes capital appreciation and income returns, including reinvestment income. So, you still have to scout for avenues to reinvest the proceeds received as dividends, if the equity investment is part of your goal-based portfolio.

Does this mean you should not position your portfolio to capture both sources of returns?

Gains and income

You can strive to achieve both sources of returns in your satellite portfolio. The satellite portfolio, which typically contains equity and commodities, is set up to capture gains from short-term price movements in the market.

Your equity investments can typically capture both sources of returns. How?

You could buy dividend-paying stocks that are poised for an upside. That way, you can also collect dividends directly from the company if you buy the stock and hold it cum-dividend.

The upshot? Your primary source of return is capital appreciation, for both your core and satellite portfolios. Income return is a bonus for your satellite portfolio.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in

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