Investments in traditional asset classes such as equity and bonds can generate two sources of returns — income returns and capital appreciation. In this article, we will discuss whether you should aim to generate and receive income returns on your investments during your work life.

Risky returns?

Income returns provide stability to a portfolio that contains capital appreciation products. The discussion, therefore, is not whether your portfolio should generate income returns. Rather, the question is whether you should receive such income in the year you earn it. That is, should you invest in products that credit the income into your savings account at the end of each year. The answer is no, for the reasons discussed below.

One, you must earn a compounded annual return through the time horizon for a goal. This applies to both your income generating investments and capital appreciation products. That means, if you expect to earn 6% on your income generating investments, it is not enough if 6% is credited into your savings account each year. That interest should be reinvested to earn 6% over the remaining life of the goal. You have a busy life. Will you be able to comb investment opportunities each year to make the reinvestment? And even if you do, what if you do not find attractive investments as interest rates had declined since you made the initial investment? Asking your bank or the issuer of the income-generating product to make the reinvestment is simpler. It also eliminates the risk that you may be unable to find reinvestment opportunities in the future.

Two, we are typically present biased. That is, we value current happiness much more than we value happiness in the future. That is why spending comes naturally to us whereas savings is an acquired habit. Allowing the bank to credit the interest income into your savings account each year is, therefore, not good from a behavioural perspective; you will be tempted to spend it. This is especially true when the goal that you are pursuing is far away or does not involve accumulating money for your child’s college education.

Conclusion

You have active income during your working life. The passive income in your investment portfolio is only to provide stable returns, as the portfolio also contains equity investments. You do not need passive income to support your lifestyle expenses until retirement. So, invest in income generating products that automatically reinvest the income.

(The author offers training programmes for individuals to manage their personal investments)

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