INCOME VERSUS GROWTH: Take it or leave it - or do both

A special report on how to choose an investment that matches your objectives

This week's investment survey (on pages 6 to 12) is about making decisions as to whether to invest your money for income or growth. Many people new to the subject will stop right there. These terms are used every week in the finance press without any explanation of what they mean or how you should interpret them.

A growth investment is designed to expand the original amount of cash you've set aside; an income-driven investment is meant to generate regular payments to you - ideally without eating into your money.

For example, shares are a growth investment. If you choose them wisely - or pay someone else to pick them for you, and hold them in a personal equity plan (PEP) or individual savings account (ISA) - then history suggests the original price you paid should go up over time: shares have, on average, grown by 12.2 per cent a year since 1918. When you buy into a growth investment you should leave your capital (the money you put into the scheme) untouched for many years.

Eventually you can sell the shares for a lot more than you paid for them. You also get share dividends, which are payments made when a company is doing well. You can re-invest these to buy more shares, or take them as income.

Some PEP funds are not designed for all-out capital growth. They are called in-come funds partly be-cause they concentrate on selecting shares with good dividend payments.

Others are called income funds because they bypass shares and buy corporate bonds (see page 11). Bonds are loans that investors make to a large company. If you invest in a corporate bond fund you can take the interest paid as your income - typically 5 to 8 per cent a year, tax free. But the key thing is you don't have to take the money as an income - you can leave it to grow. That's why the distinction between growth and income can be confusing.

You can get an idea about how fast a particular investment will make your cash grow by looking at the marketing bumf. If it is a "managed growth" investment then it's under tight control and you won't be taking too many exciting risks. Your money will go into a mix of different investments such as property and government bonds as well as shares.

An "aggressive growth" investment will take more risks with your original stake, but you should not rule this out right away. It does not mean you have to invest in Japanese warrants; you can choose aggressive growth close to home.

"Funds which invest in UK smaller companies do exactly that - go all- out for growth," says Mark Dampier, head of collective investments at Har-greaves Lansdown. He also suggests a "special situations fund" is set up for potential fast-track growth. This sort of fund buys shares in companies that have had problems. Although many of these will be small and medium-sized firms, you may also find a troubled giant like Marks & Spencer. (Fidelity runs a successful fund of this type.)

A pure "income" investment is often aimed at people who are either about to retire or already living on a pension and looking to boost their day- to-day cash flow. Most income-centred schemes try to protect your capital as much as possible but you won't get a lot of capital growth. For example, five-year "guaranteed" bonds will pay you a fixed amount of income each year during the term, but this may be at the expense of some of your original cash - you may well get back less at the end than you put in at the start.

However, the choice is not as simple as saying you should look for growth or income. For example, a with-profits bond is often recommended by company salespeople and independent financial advisers (IFAs) both to cautious growth investors and to those looking for an income.

That's because these bonds offer the prospect of some capital growth through an annual bonus payment (currently about 6 per cent a year) which makes up for any income you take out of the bond. You can take 5 per cent of your original capital each year before you get involved with paying extra tax, even if you are a 40 per cent taxpayer. So a pounds 20,000 lump sum would generate pounds 1,000-worth of income a year. (See page 12 for more on with-profits bonds.)

If you took the full 5 per cent to live on and received 6 per cent back then your capital would be growing, but at a rate below inflation. Unless bonus rates improve, the real value of your cash is eroding every year.

Growth investors who do not take any income from the bond would see much bigger returns because of the effects of compound growth. This means the money you earn each year goes on to earn interest, so you get a double benefit. That concept is at the heart of growth investing, and it's why money you save in your 20s and 30s is so much more valuable than anything saved later (see page 8). Over time, a small amount saved each month can produce a huge amount of cash. The trick is to find the right place to put it.

A growth investor who does not understand much about the stock market may well use a financial adviser. Fine, but bear in mind that these salespeople all have to abide by strict rules against selling you the wrong type of investment. They have to fill in a questionnaire based on an interview with you and then recommend products on the basis of your answers. But how can you discuss your "attitude to risk" if you don't really understand what that involves?

The vast majority of salespeople, whether they are tied to one firm or independent, need commission payments from financial firms to survive. This means they tend to recommend "safe", traditional investments from firms that pay healthy commission. A with-profits bond fits the bill exactly. It's hard to prove it's not suitable for cautious growth investors, and it's fine for income-seekers. And as the salespeople don't have to pick the cheapest products (they just have to tell you how much commission they earn), you won't necessarily be presented with cheaper alternatives like unit and investment trusts that are designed to leave you at a low risk of losing your capital.

The problem with this "income vs growth" division is that most of us don't have such stark investment aims. And many sorts of investment (such as bond PEPs and buy-to-let property schemes, see page 9) should let you mix growth and income. We've tried to reflect that mix in these pages, and suggest ways to go for growth alone or take an income without eroding your original investment.

If you are inspired to try your hand at growing your cash through direct investment in shares, read our weekly column by the Motley Fool (see page 14 or visit www.fool.co.uk).

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