2nd November, 2018
The Hidden Power of Income
Albert Einstein famously once said “compounding is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it”.
There are two ways an investment can give you a return, it can produce an income, or the capital value can rise. In the case of income, we all have a choice on whether to receive it and spend it (like getting our dividends as a cheque in the post), or reinvest it. Bank accounts automatically reinvest interest – you don’t physically get given it – it is added to your account and counts towards the next time interest is calculated. Receiving interest on the interest is the general idea of compounding.
When it comes to the DB Wood Portfolios, there are similar options – you can choose accumulation units (reinvesting income) or income units (receiving it as cash). Our Low to Medium Portfolio for example, has a current income yield of 2.4%. This means that if markets stood still over the course of the next 12 months, this will be your return. Our aim is to also generate some capital growth through price increases over the longer term. When added to the income return, we are aiming to achieve 4%-6% per annum from this portfolio.
The income component is significantly more predictable than the capital component. Like we have seen this year, there will be periods in every economic cycle where markets get jittery, and capital values fall. Here though, lies the real opportunity. Provided you have chosen to reinvest your income; you have the opportunity to reinvest at a cheaper price, which means when your capital values rise again you have more units to benefit from that rise. Consider the following example…
David and Claire invest £100 and with that buy 100 units (£1 per unit). They choose to reinvest their income.
Over the course of 12 months their portfolio falls by 20%, meaning they still have 100 units, but their portfolio is now worth £80.
At the end of that 12 months the portfolio pays an income of 4% (£4), which is reinvested so they now have 105 units and the portfolio is worth £84.
In the next 12 months their portfolio increases by 25% (this is exactly equivalent to a 20% fall in value), meaning they now have 105 units, and their portfolio has risen to £105.
If they had not chosen to reinvest their income, the £100 would have fallen to £80, they would have received £4 in cash, and then the £80 would have gone back to £100. So overall they would have received £104 back.
By reinvesting their income, they have created an extra £1 in value, or 1% return.
This may not seem like a huge deal, but here we are looking at just one reinvestment opportunity. Over the long term, the combined effects of many of these events (Einstein’s compounding) can make a huge difference to the result. We often say that volatility breeds opportunity, and usually we are talking about the ability for us to buy in to markets when they are cheaper (just as we did last week). The benefit of reinvesting income, or “yield” as many call it, is often overlooked though, and it is another powerful tailwind to help your long term returns. So when markets are falling, be reassured that not only are we working harder than ever for you, so is your portfolio.