SMSF Investment StrategiesSharing Simple Strategies for Self Managed Super Funds
Growth vs Income Investments
A number of events in recent days have made me reflect on our conventional thinking of growth vs income assets. Growth assets such as stocks and properties have always been associated with savvy investors who dare to take risks and are usually rewarded with bigger returns. Income assets are usually associated with risk averse investors who stick with safe assets which provide poor returns. A few weeks ago, we sold the last of our investment property for four times the purchase price or a 300% profit. It sure sounds like a fantastic investment return but was it really? It took twenty years for the property to reach this price so this works out to be only a 7.3% annual return, before tax.
Investors tend only to remember the purchase price of growth assets. If the current value of our asset is more than our purchase price, we are happy and we do not really think about whether it is a good investment or not, based on an annual percentage return. Below is a 20 year chart of BHP. In October 1991, you could have purchased BHP for around $15 per share. Based on today’s price of around $36 per share, this investment would have unrealised capital gains of 140% but an annual return of only 4.5%. BHP also pays a small dividend but if it did not (like a lot of other mining companies), this annual return is comparable with the typical return of a long-term government bond!
New investors are naturally attracted to growth stocks as they offer the potential of huge capital gains like what we saw in 2003 to 2007. But “growth” can be both positive and negative. Investors who bought BHP shares in 2001 or 2008 would have had a scary ride as they watch the value of their investment fall 50% and had to wait 3-4 years just to “break even” again. When I first started investing, I spent a lot of time looking for stocks that would provide large capital gains but now I tend to look for good annual returns on capital invested. For example, an investment in a good income stock which provides a steady 4-5% fully franked dividend would have outperformed an investment in BHP even if the share price of that income stock remained unchanged over the 20 years.
A common criticism of income investments is regarding the need to pay tax on income whereas capital gains are not taxed unless you sell your investments. Accountants especially tend to focus on the tax implications but isn’t it better to realise a profit and pay tax on it than to watch unrealised profits disappear when prices fall? I always remember the advice of one of our investment mentors who said “Paying tax is a good problem to have”, because the only time you pay tax is when you have made money – something we often forget, so simple and yet so true. The best way to manage tax is to keep your investments in a tax friendly environment such as a super fund or a trust. I prefer to pay small amounts of tax on earned income rather than a huge capital gains bill at the end. We will have to pay a large amount of capital gains tax from the sale of this investment property and this has held us back from selling earlier. In hind sight, it was probably not a good decision to delay the sale as we probably would have got a better price earlier this year and saved on paying interest to the banks. Ah well, hopefully we will learn from the mistakes in this investment and make sure we don’t make the same ones in our next one.
Digressing slightly from this topic … I would like to thank my readers for the fantastic response to my pilot program. At this stage, I am going to close this while I work through this and use the feedback to improve the program. Stay tuned as we head towards a formal launch in February 2012.
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