Many investors are suffering from the ‘low return blues’ at present; interest rates are low, shares remain unstable and the property market has been weak. Investing capital in these markets is indeed challenging.
However, we can be thankful for what we have that others don’t; relatively high interest rates and dividend yields, and decreasing personal tax rates.
There are some 820 million people living in countries with official interest rates of 1% or less. We are fortunate in that we can find deposit rates of 4 to 6% and dividend yields on shares of 5% or more.
Consider investors in the US, UK, Europe and Japan where deposit rates are only just above zero – call deposit rates of 0.2% are the norm in the UK at present – and dividend yields on shares average 2.5%.
The best investment advice that investors can take at present is to simply accept that returns are going to be lower than they have been in the past.
Although property prices have weakened over the past two years, investing in housing remains questionable and rental yields are still relatively low. Real estate investors will need to accept more modest returns, which will be driven largely by cash flow, rather than by significant capital gains.
Looking at fixed income, the days of 10% ‘risk-free’ returns are well behind us. The Reserve Bank lists the six-month deposit rate as 4.7%. In the bond market, a five-year government bond is yielding 4.2%, highly rated 5-year corporate bonds around 6.0%, unrated higher-risk corporate bonds with the same maturity average about 7.5% and 5-year bank term deposits of 6.5% are available. All up, a diversified and laddered fixed income portfolio may provide an overall return of 6.0 to 6.5%.
Moving onto the equity market, an investment portfolio of blue chips from here and overseas can be put together that will produce a forecast pre-tax dividend yield of 5%. A number of leading New Zealand companies are offering higher yields than this, and a NZ portfolio might generate a pre-tax dividend yield of 6.5% or more. After including overseas shares where yields are lower, the yield is diluted somewhat.
Helpful investment strategy advice for handling tough markets is to focus on income. Within equities, dividends are often overlooked as many people focus on trying to find capital growth.
While many investors avoid shares because of the risks involved and invest only in fixed income. However, they are an important part of a portfolio in our view as they provide income from dividends as well as the potential for income growth and protection against inflation. Even a modest allocation to shares should be considered.
We do agree that shares are volatile. Our market fell 40% over 2008. It has since recovered close to 30% from its 2009 low point, but is still 25% below its 2007 peak. Which brings us to our next strategy, diversification. While investing in fixed income means lower potential returns, it also means lower risk.
When it comes to diversification, you have an unbeatable strategy in all markets. Combine fixed income and shares together in a mix that suits your tolerance for risk. There is clearly a trade-off involved. When you invest in fixed income you give up higher potential returns, but you do get more certainty. Shares offer higher rewards, but come with attached uncertainty.
Given the modest returns that are likely over coming years it is worth turning to one of the most fundamental but powerful investment rules of all time – compounding.
For those whom it is a viable option, you should aim to reinvest the income from your portfolio and let the power of compounding returns work its magic.
Take a look at our guesstimate return for shares of 8.5 %, a $10,000 investment in shares for 20 years will return 7 % a year if net income is reinvested but only 5.7 % a year if income is spent. This extra 1.3 % a year may sound relatively modest, but it means the end value of the reinvested portfolio is 30 % larger. So, if you are investing in shares and don’t need the income, be sure to reinvest those dividends.
The environment for investors investing is undeniably tough at present, but arguably it always is. It is important to have realistic return expectations, focusing on income, compounding income where possible, including shares in your portfolio while keeping a good balance between fixed income and shares, investing gradually and ignoring sentiment are all strategies that should be a salve to the low-return blues.
