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

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