Secrets of Success: Your motives are the key to your profits

What is the purpose of investing your money? The answer varies enormously, from individual to individual, and from institution to institution.

What is the purpose of investing your money? The answer varies enormously, from individual to individual, and from institution to institution. The answer effectively determines the way that you put your money to work, whether you are a pension fund or charity, with pre-determined objectives, or an individual looking to build some capital, pay school fees or simply generate income.

The nearer and more specific the investment objective is, the more constraining it becomes. If you absolutely need £5,000 in five years' time for school fees or your daughter's wedding, and you think you cannot afford to come up short, it severely restricts your choices of where to invest.Even an investment that has only a 10 per cent chance of failing to meet the target can end up being rejected, despite the fact that nine times out of 10 it will be expected to produce substantially more than you need.

At the other extreme are those whose time horizons are infinite and objectives generalised. In the case of individuals, these might be those lucky few who have made a pile from business and are putting their surplus money to work. They can afford to put money into higher-risk ventures such as private equity and venture capital, and often end up making even more money than before.

In the case of institutions, some charitable foundations with loosely defined objectives fall into a similar camp: they can take more liberties with their capital. One reason why the rich tend to get richer and the not-so-rich stay not-so-rich is that the rich are not liquidity-constrained when investing their money and so in aggregate can afford to have more money in risky assets, which produce higher returns over time.

One issue is common to all investors in today's investment climate. Falling inflation and interest rates over the past 30 years have created an environment in which the balance between income and capital return from investments has altered dramatically. When interest rates are as low as they are today, it is not possible to generate as much return in the form of income as it was before.

Can it be sensible or right to risk consuming capital to generate a return from an investment? In the 19th century, when inflation was largely non-existent, capital values changed little and it was customary to measure your wealth only in terms of the income it generated. Consuming capital was widely seen as the ultimate sin.

But is that still the case today? In theory, there is no reason why an investor should not generate a return, whichever way is most appropriate. If you take the dividend from a share or investment fund and sell a small proportion of your holding each year to generate an additional cash return, it need not necessarily reduce your remaining capital if the underlying asset is growing faster in real terms than the slice you take out in this way.

In practice, for individuals, the choice of taking return as income or capital gain at the margin is heavily driven by tax considerations, and in the case of shares by transaction costs as well. Nevertheless, it may often be a better solution than doing what many people do, which is to put their money into instruments that have above-average yields but actually eat into their capital either surreptitiously (by returning capital disguised as income) or, worse still, by taking risks they do not appreciate.

For many organisations with long time horizons, such as family trusts and charitable foundations, the issue of how to balance capital and income returns is also a very real one, as they have to decide each year how much money they wish to spend. According to an interesting paper I saw recently, many charities and foundations are falling into the trap of underestimating the cash-generating potential of their funds.

Two common rules of thumb in foundation land are that it is safe to spend 5 per cent of the assets each year without compromising the foundation's long-term survival; and that as long as the trustees are maintaining the real value of the assets from year to year, they are doing a good job. Many have continued to assume that it is okay to have a high proportion in equities because they are the most rewarding long-term asset. Yet these assumptions are not well-founded in today's markets. What matters in such cases is not what happens to the market value of the foundation's assets, which can be very volatile, but their cash-generating potential, and this has fallen dramatically as a result of the change in yields and valuation parameters over the past 25 years. At the same time, the high market valuations risk substantial erosion of the capital base.

In 1981, according to the paper, when dividend yields were high and price/earnings ratios low, a foundation with £1m in assets had the potential to produce between £50,000 and £100,000 in sustainable cash returns. But today, even if the asset had kept pace with inflation, the potential sustainable return is less than £40,000 and may be as little as £20,000.

What this means in practical terms is that many foundations are probably living and spending beyond their means. They have already had a shock from the bear market of 2000/2003, but there may be more to come. The risks can be demonstrated mathematically, but are hard to convey. The reality is that in a low-inflation world, and coming out of a period of gloriously extravagant excess returns from shares, bonds and property, income is set to become a much more important component of all future investment returns.

jd@intelligent-investor.co.uk

Independent Partners; Do you need financial advice on your investments, pension or insurance? Book a free consultation with an independent Financial Adviser at VouchedFor.co.uk

Finacial products from our partners
Property search
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

ES Rentals

    iJobs Job Widget
    iJobs Money & Business

    Guru Careers: Pricing Analyst

    £30 - 35k: Guru Careers: We are seeking a Pricing Analyst to join a leading e-...

    SThree: Trainee Recruitment Consultant

    £20000 - £25000 per annum + OTE £45K YR1: SThree: At SThree, we like to be dif...

    SThree: Trainee Recruitment Consultant

    £20000 - £25000 per annum + competitive: SThree: Did you know? SThree is a mul...

    Guru Careers: C# Project Team Lead

    £55 - 65k (DOE): Guru Careers: A unique opportunity for a permanent C# Develop...

    Day In a Page

    Fifa corruption: The 161-page dossier that exposes the organisation's dark heart

    The 161-page dossier that exposes Fifa's dark heart

    How did a group of corrupt officials turn football’s governing body into what was, in essence, a criminal enterprise? Chris Green and David Connett reveal all
    Mediterranean migrant crisis: 'If Europe thinks bombing boats will stop smuggling, it will not. We will defend ourselves,' says Tripoli PM

    Exclusive interview with Tripoli PM Khalifa al-Ghweil

    'If Europe thinks bombing boats will stop smuggling, it will not. We will defend ourselves'
    Raymond Chandler's Los Angeles: How the author foretold the Californian water crisis

    Raymond Chandler's Los Angeles

    How the author foretold the Californian water crisis
    Chinese artist who posted funny image of President Xi Jinping facing five years in prison as authorities crackdown on dissent in the arts

    Art attack

    Chinese artist who posted funny image of President Xi Jinping facing five years in prison
    Marc Jacobs is putting Cher in the limelight as the face of his latest campaign

    Cher is the new face of Marc Jacobs

    Alexander Fury explains why designers are turning to august stars to front their lines
    Parents of six-year-old who beat leukaemia plan to climb Ben Nevis for cancer charity

    'I'm climbing Ben Nevis for my daughter'

    Karen Attwood's young daughter Yasmin beat cancer. Now her family is about to take on a new challenge - scaling Ben Nevis to help other children
    10 best wedding gift ideas

    It's that time of year again... 10 best wedding gift ideas

    Forget that fancy toaster, we've gone off-list to find memorable gifts that will last a lifetime
    Paul Scholes column: With the Premier League over for another year, here are my end of season awards

    Paul Scholes column

    With the Premier League over for another year, here are my end of season awards
    Heysel disaster 30th anniversary: Liverpool have seen too much tragedy to forget fateful day in Belgium

    Liverpool have seen too much tragedy to forget Heysel

    Thirty years ago, 39 fans waiting to watch a European Cup final died as a result of a fatal cocktail of circumstances. Ian Herbert looks at how a club dealt with this tragedy
    Amir Khan vs Chris Algieri: Khan’s audition for Floyd Mayweather may turn into a no-win situation, says Frank Warren

    Khan’s audition for Mayweather may turn into a no-win situation

    The Bolton fighter could be damned if he dazzles and damned if he doesn’t against Algieri, the man last seen being decked six times by Pacquiao, says Frank Warren
    Blundering Tony Blair quits as Middle East peace envoy – only Israel will miss him

    Blundering Blair quits as Middle East peace envoy – only Israel will miss him

    For Arabs – and for Britons who lost their loved ones in his shambolic war in Iraq – his appointment was an insult, says Robert Fisk
    Fifa corruption arrests: All hail the Feds for riding to football's rescue

    Fifa corruption arrests

    All hail the Feds for riding to football's rescue, says Ian Herbert
    Isis in Syria: The Kurdish enclave still resisting the tyranny of President Assad and militant fighters

    The Kurdish enclave still resisting the tyranny of Assad and Isis

    In Syrian Kurdish cantons along the Turkish border, the progressive aims of the 2011 uprising are being enacted despite the war. Patrick Cockburn returns to Amuda
    How I survived Cambodia's Killing Fields: Acclaimed surgeon SreyRam Kuy celebrates her mother's determination to escape the US

    How I survived Cambodia's Killing Fields

    Acclaimed surgeon SreyRam Kuy celebrates her mother's determination to escape to the US
    Stephen Mangan interview: From posh buffoon to pregnant dad, the actor has quite a range

    How Stephen Mangan got his range

    Posh buffoon, hapless writer, pregnant dad - Mangan is certainly a versatile actor