Income in a low interest and volatile environment
Written and accurate as at: Aug 06, 2020 Current Stats & Facts
With central bankers around the world, committing to keep interest rates low for many years to come, this creates an issue for investors reliant on income. The traditional method of holding assets such as cash, fixed income and dividend-bearing shares to produce sufficient income to meet expenses is no longer reliable. It is time for self-funded investors to rethink income.
For many self-funded investors, the objective to fund their lifestyle from the income generated by their investments while preserving capital is common. However, while yields remain low, this isn't a practical or reliable strategy. Funding lifestyle expenses through with a combination of capital and income is no longer an option but mainly a requirement.
Fortunately, there are several methods investors may consider to help manage this puzzle; we will discuss the following three.
- Household Spending
- Effective diversification
- Absolute/total return
Spending
According to real-time spending tracker, discretionary spending, which includes leisure, entertainment, cafes and personal care, was almost a third lower than average during the peak of the COVID crisis. The figures abruptly reversed, erasing savings as discretionary spending soared nearly doubling the lows of March.
Now is an excellent time to take stock to identify your expenses, understand the purpose and determine the value. Establish a well-structured budget and complete a register of your financial records. We have developed the Integral Private Wealth client portal to help serve this purpose. It is available on the Apple App Store and Google Play.
Effective diversification
Portfolio diversification is often described by the idiom of 'not putting all your eggs in one basket', meaning to invest in a range of different assets to mitigate risk. The concept suggests that if one investment falls in value, other investments may increase, which in theory could smooth the return and limit the volatility. Adequate diversification requires careful consideration. For example, consider a portfolio holding Westpac Bank and Commonwealth Bank shares. Given both of these shares are Australian banks, the performance of these two companies is relatively similar and considered to be highly correlated. Correlation is a statistic that measures the degree to which an investment behaves with another. The greater the similarity, the higher the correlation, conversely, the lower they reflect performance, the more negative the correlation. Correlation measures on a scale of -1.0 to +1.0:
If two assets have an expected return correlation of 1.0, that means they are perfectly correlated.
If one gains 5%, the other gains 5%. If one drops 10%, so does the other. A perfectly negative correlation (-1.0) implies that the different asset's loss proportionally matches one asset's increase.
A zero correlation indicates the two assets have no predictive relationship. Modern portfolio theory suggests investors build a consistently uncorrelated (near zero) portfolio of assets to limit risk. In practical terms, that virtually guarantees a diversified portfolio, albeit achieving it isn't as simple as merely holding a randomly selected range of shares, property, bonds and cash. Indeed the current market is an essential reminder of the need to have an intimate understanding of the investments within the assets themselves.
The big four banks and the large miners represent approximately 28% of the ASX100. The performance of this small number of companies is likely to determine the outcome for most of the market. Bonds typically form the backbone of a defensive portfolio; however, the correlation between bonds and shares has increased in recent years. One reason being artificially low-interest rates which have reduced the diversification benefits for parts of the market such as government bonds. Investing in fixed income now needs a very selective approach to achieve the desired risk-reward. The listed property market may provide some level of diversification being mildly positively correlated. Investors should be cognisant of these traits if they want to diversify their portfolio adequately.
Diversification isn't limited to the allocation of capital across a range of asset classes but also applies to income. Investors should consider a mix of yielding assets within the portfolio to smooth income produced throughout the year. While some investments may seem similar, a prime differentiator between them may be the frequency of dividend, distribution or yield payments and the terms on which they distribute. Further to this, unlike bonds, whereby coupon payments must distribute unless the issuer defaults, dividends are far from guaranteed. Investors in blue-chip stocks often look at the historic yield as a guide to future payouts. Still, if profits fall or it needs to improve its balance sheet; these dividends can be cut, deferred or abandoned altogether. Some of the previously high paying stocks on the Australian market have done this in recent months which is troubling for income-seeking investors. Dividends are not annuities and therefore, are not guaranteed. The current recession could further subdue dividends at least in the short-term. Investors seeking dividends and franking credits may need to look more broadly across the Australian share market.
Market volatility is always a factor in markets. With interest rates being close to zero, many more are taking the plunge with the market without considering the significant risks. Capital will be the source to pay lifestyle expenses more than ever, as such managing risk is critical. A volatile market at the same time you have a payment or need to top up your savings account to meet your lifestyle expenses could be devastating. Being adequately diversified is a crucial strategy to help reduce the possibility of being forced to sell an asset at its lowest point.
This ongoing crisis reminds us is that in times of market stress, the return of capital takes precedence over return on capital.
A total return approach
Another option is adopting a total return method to investing and systematically drawing down capital. One such strategy is the 'bucket' approach which involves dividing investments into different short, medium, and long-term buckets. Importantly, when implementing this method, investors need to be mindful of the diversification integrity and alignment to risk profile.
This approach involves segmenting your investments into three buckets (in retirement these might be held in your account-based pension):
- A 'cash bucket' with cash investments to fund your short-term retirement lifestyle (expected lump sum withdrawals and regular pension payments) over the next one to three years;
- A 'stable bucket' with other income-generating investments (e.g. fixed interest) to help account for an additional three to five years of retirement income; and
- A 'growth bucket', investing the remaining funds in risky assets such as shares and property with the aim of long term capital growth.
The cash and stable buckets are replenished periodically, with enough funds to continuously cover a rolling four to seven years of expected lump sum withdrawals and regular pension payments.
Depending on the strategic approach taken, this could occur:
- At the end of the four; seven-year period;
- Periodical reviews; or
- Should the third or 'growth' bucket increase disproportionately to the other buckets, causing the portfolio to become misaligned with the investment risk profile.
Every investor is different in many ways. Whether it is the risk appetite, investment time frame and financial needs (growth, income or combination?) amongst others.
Regardless, it has never been more critical to plan and never so crucial to be prepared.