Investing for income at a time when interest rates are at historical low levels is currently a real challenge for some investors. In fact, a frequent question raised to our Investment Management Team is:
“How can I generate an income without adding too much risk?”
The investment horizon has changed significantly over the last few years and investors can no longer expect a steady 5% annual return without being exposed to some investment risk. Before the banking crisis in 2008, a savings account would typically yield 5% per annum, whereas today the average is well below 2% and that’s before the deduction of tax. If you also factor in inflation, which is currently above 2% there is significant risk of a negative real return. In order to maintain this level of income therefore, investors need to look at alternative assets which ultimately can mean accepting more risk, although the potential returns are substantially increased.
One way our Investment Management team can look to achieve a good level of income in the current climate, whilst moderating the investment risk, is by creating a diversified portfolio that is split across a range of assets and therefore diversifying the overall risk. The level of diversification and split of assets is however, very much dependent on the individual’s circumstances and factors such as age, attitude to risk and investment horizon all need to be taken into consideration.
Asset allocation is pivotal to our overall investment strategy and aims to balance risk versus return through a range of assets classes.
Cash and deposits
Cash and deposits remain a core holding in our overall planning, despite investors not currently being rewarded for holding cash. As mentioned above, Inflation is the biggest risk here as currently inflation remains well above the Bank of England’s 2% target. Many investors are seeing a negative real return on their assets and are now looking to diversify, in order to achieve a better return. Within our overall asset allocation we would however, always consider holding a proportion of funds in cash as this provides both capital security and access to capital in a low risk environment. It is also appropriate for shorter term investment horizons.
Fixed interest investments
Fixed interest investments are often known as bonds and come in many different guises. A fixed interest security is a loan to either a company (Corporate Bond) or to a government (Gilt). In return the company or government pay a fixed rate of interest until the end of the term when they will pay the money back. There is a risk with bonds that the company or government will default on the loan and are unable to repay the interest or the full loan amount back. In overall terms, fixed interest investments are considered more risky than cash, but less risky than other asset classes.
Absolute return funds
Absolute return funds aim to produce a positive return, irrespective of market conditions, typically by using several different strategies to achieve the return. The inclusion of this sector in our portfolios provides additional diversification in a manner that has minimal correlation to the stock market. This suggests that the trend on the stock market at any one time will not necessarily result in this sector moving in the same direction and is included as a ‘core holding’ of lower risk investments.
Commercial property
We can access the commercial property market by purchasing into funds which themselves purchase the bricks and mortar of commercial property and can be a useful investment to generate income for investors.
Commercial property tends to be valued by reference to the amount of rent paid and as leases tend to be over a ten to fifteen year period, this also tends to give the fund lower levels of volatility. Increases in the rent can provide for capital growth over time, whilst at the same time, the rent paid provides a useful additional income.
Investments into the commercial property sector are considered a useful diversification in a portfolio, due to different investment characteristics and low correlation to equities. However there are risks that the funds can become subject to poor cash flow, or liquidity. Yields remain attractive compared to other assets and offers potential for capital growth over the long term.
UK equity income
UK equity income investments are a core holding in our investment portfolios as investments in this sector provide a reasonable income with the potential to improve year on year
An investment into this sector is into shares primarily traded on the FTSE 100 Index. These shares tend to be in companies of higher capitalised value and therefore are at the lower end of the equity risk scale. These shares pay a dividend which is the distribution of corporate profit and the current average yield from this sector is between 3% and 4% which can provide a useful income. This is comparatively high when compared to current deposit rates and also outstrips the current rate of inflation. From an investment perspective, the reinvestment of the dividend can also serve to reduce risk by cushioning falls in capital values, and at the same time exaggerating gains.
Our approach to investing for income utilises well researched and respected income producing funds, spread across a range of global markets which creates a diversified portfolio that can reduce volatility.
Please note that past performance is not a guide to future performance. The value of an investment can fall as well as rise as a result of market and currency fluctuations and you may not get back the amount originally invested.
How Nelsons can help
If you are interested in a initial consultation meeting to discuss this, or any other aspect of financial planning then please contact Phil Terry, an Independent Financial Adviser in our Investment Management Team on 0800 024 1976 or via our online form.