When it comes to managing investments, a big source of confusion is the relationship between income, return, cash flow and capital. These four things come together make investments grow and to provide funds for the enjoyment of life. Different approaches are needed depending on what your financial goals are.
When people say they want a good income from their investments, what they usually mean is something completely different. If they are growing their wealth, they really mean they want a good return. Return is the total sum of income and capital gain. The return from a rental property is the sum of the net income received and the change in the value of the property. For shares, it is the dividends paid plus the change in value of the shares. On the other hand, investments such as bank deposits don’t change in value and their return is simply the interest income. If your goal is to grow wealth, a higher return can be achieved by investing in assets which change in value.
At a point in time, usually retirement, the goal changes from growing wealth to providing funds to enjoy life. At this time, when people say they want a good income from their investments, they really mean they want good cash flow. Cash flow is the total sum of income and capital drawdown. Investing for cash flow is not the same as investing for income and opens up the possibility of investing funds for both income and capital gain. They key issue is to manage liquidity – that is, to ensure that money (either income or capital) is available when required. Retired investors should not be constrained by living on the income from capital; they should use capital as well as income to provide the money needed to enjoy life.