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Capital Growth is Key to Finding Income in a Zero-Inflation Era

Updated: May 17, 2022

Whether because of covid-19 or otherwise, the quest for yield has in recent times been strewn with casualties. Where and how can investors find reliable sources of income? In an age of low inflation, pandemics and other global risks, the answer to this question may require some lateral thinking.

"In the early ’80s it was easy to find 10% yielders"

The last few years have seen several notable financial failures, for example minibond London Capital and Finance and AIM-listed Patisserie Valerie. Financial instruments promising high yields and AIM constituents that entice with higher growth and income prospects appeal particularly to retail investors. Disasters in these realms can thus be particularly painful, all the more so when a failed investment comprises a large share of a portfolio.

My Last Word column in February of this year cited poor investor education as a major problem in the UK. I stand by everything I wrote but feel the need to continue to write about the issue.

The common thread of my written articles on the subject is that successful investing is hard. More to the point, unlike brain surgery or flying a helicopter, it is often not understood just how hard successful investing is, the reason being that it is easy to set up an investment account and place trades. No training or education is required – just the ability to use a finger or two.

Part of the problem lies not within us but relates to the persistent and significant fall

in inflation over the last four decades. In the early ’80s, it was easy to find 10% yielders because long-term interest rates – gilt yields – were around 10%, reflecting high prevailing inflation.

With inflation now close to zero, a 10% yielder today is arguably the equivalent of a 20% yielder in 1980. In other words, very risky. If you do not adjust your expectations, you may fall into the trap of thinking that it is reasonable nowadays to expect to find safe-ish 10% yielders.

Furthermore, economic growth in the 1980s was stronger than it is today, so failures may have been less common. The rise in financial engineering has perhaps in recent years also introduced more scope for poorly structured products to reach the retail investor.

However, the main problem I think is behavioural: the age-old desire that exists deep within us to ‘get rich quick’. It is no surprise that if driven by this primal urge we are less likely to be as discerning as we should be when presented with an exciting investment opportunity.

A good starting point would be to stop thinking in terms of income or dividend yield and start thinking in terms of total return. Equity dividend yields in relation to long- term real gilt yields still look attractive, particularly so because of Brexit-driven uncertainty.

If monetary and fiscal policies can continue to stave off a pronounced economic downturn, low inflation and interest rates may see equity valuations and thus equity prices driven higher in the medium term.

In such an environment, capital growth would contribute significantly to total return, growth that could be converted into income via the sale of investments – fund units or shares – allowing an investor to consider lower yielding investments such as tech or pharma companies that he may otherwise have avoided.

The problem with this approach – if indeed it can be described as a problem – is the additional administration relating to the calculation of sales required to top up income, followed by order execution. Considering it investor education may help to make it feel less onerous.

Published in What Investment

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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