The quest for cashflow

Look beyond the banks if you want income from your investments - but be sure you understand the risks you're taking, advises DAVID McEWEN.

Contrary to popular opinion, New Zealanders are pretty good savers.

Where we seem to struggle is not in accumulating money but in investing it. There is a widespread inability to accurately judge risk and returns.

Many investors are extremely conservative - $26 billion is merely sitting around in bank accounts says a report by the Statistics Department and the Retirement Commissioner entitled The Net Worth of New Zealanders.

Others take enormous risks on dotcom shares, Queensland properties, ostriches and corporate junk bonds.

Most people tend to invest for income, hence the relatively high dividend payments by many listed companies.

In theory, investors who want income should be making sure it is relatively stable and that means holding assets that won't deliver a major capital loss if things go wrong.

Unfortunately, many investors think only of maximising their income and ignore the risk to their capital.

This is dangerous, as in some cases the capital loss can be 100 per cent.

As investment advisers like to say: "The higher above 10 per cent a yield goes, the closer it gets to zero."

Investors need to know the risks they are taking with different asset classes, and what returns they need to get to justify each category of risk.

To do this it helps to define your goals.

Ask yourself how much income you want your investments to produce, and from when.

This will dictate how much risk you need to take. Most people want income from their investments after they retire. Those who are still earning a wage or salary tend to focus on building up their nest eggs by chasing capital gains and reinvesting income.

The typical portfolio includes shares, cash (money in the bank), fixed interest (Government stock and corporate bonds) and property.

Shares fluctuate in value more readily than other assets, but over the long term they deliver the highest return of any asset class.

But the income seeker should look for a particular type of share, one that pays high dividends and operates in stable industries.

Bonds suffer less severe price fluctuations and have much lower overall market risk. But inflation risk tends to be higher, and long-term returns lower than shares. Money market instruments carry no market risk, but lack the potential to outpace inflation. In terms of risk and return, property rates between bonds and shares.

The person reaching retirement should avoid the extremes of safety and risk. Some still believe that term deposits are the only real safe haven for their money. But after deducting tax, money in the bank seldom beats inflation, which means you can expect the systematic decay of your nest-egg.

At the other extreme, there are those who chase higher returns by investing in risky investments paying very high returns. The problem is, many of these investments don't sound risky. They could be marketed as a bond or mortgage "unconditionally secured" or "first ranking debt" - words that resonate with safety.

But these terms don't mean much. Investors can find to their cost they have precious little security after Inland Revenue, the bank, lawyers and accountants have taken their slice.

One of the best ways to manage risk is by spreading funds across a portfolio of assets. The theory being that if one security or asset class suffers, the others won't be hit as hard or might even go up.

Here is a quick rundown on each asset class.

Shares

Income seekers often avoid shares because of their volatility. But there is a category of shares that pay good dividends, mostly tax-free, which are relatively low risk when collected together.

Energy companies and other utilities are often found in yield portfolios, because they are often monopolies generating a lot of cash, which they pass on to shareholders in the form of dividends.

The downside to high-yielding shares is that they often provide little capital growth. Because they are in mature industries, their share price climbs very slowly, if at all. But it is the dividends the yield investor wants, plus any modest capital gains that could bolster their portfolio.

In selecting high-yielding shares for a conservative portfolio, it is important to look out for characteristics such as steady earnings growth, stable dividend payouts, market dominance, low debt and consistently high cash flow.

Property

The property component of a portfolio can include investment in high-quality property syndicates, offering higher yields than those available on most fixed-interest investments. But the best are hard to find and are often marketed privately through solicitors and others specialising in the field.

The ones marketed to the public often deliver a poor relationship between risk and reward and are loaded with up-front costs that erode the value of the investment.

Property trusts can be more attractive because they are liquid (in other words, they can be traded), and each has a large portfolio of properties to spread the risk of ownership.

A more radical option is taking advantage of the capital in the family home to buy an investment property directly, which then forms part of a portfolio. But this can be risky because it offers little diversification by geography or income stream. Investors should go down this road only if they are prepared to spend time becoming familiar with the property market and all the intricacies of buying and holding property. But it can be a lucrative pastime for those willing to make a go of it.

Bonds

There is virtually no credit risk in Government stock, because the Government has the ability to raise taxes to ensure it can pay its obligations.

But there is interest rate risk. If interest rates rise, Government stock will lose value along with shares and the other asset classes. That's because investors will be demanding higher returns, and the bonds' face value must fall in order for the yield to rise.

Nevertheless, Government stock is an important component to the yield portfolio, as are the higher yielding corporate bonds.

Cash

This is the most liquid investment of all. But it tends not to deliver a high yield and should make up only a small part of a portfolio unless funds are needed for a specific purpose. This category is useful as an emergency fund, however.

Having carefully decided what portion of your savings should be invested in each asset class, it then becomes important to make sure the relationship between each class stays the same. This is to ensure the relationship between risk and return doesn't get out of whack.

Every investor is different and therefore so is every portfolio. Creating and managing one is a big job and is best done with the help of an adviser. Make sure you find a reputable one, however, and find out what their fees are going to be before committing yourself.

* David McEwen is managing director of Investment Research Group.

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