‘Consume Income, Not Capital’ Mind-Set Risky for Consumers in Low Interest Rate Environment

The combination of a low interest rate environment and an ingrained reluctance amongst investors to finance consumption out of capital is resulting in many South Africans searching for yield producing investments in order to fund their lifestyles. According to Wilhelm Hertzog, portfolio manager of RE:CM, this tactic is dangerous, as chasing yield bring about significant risk for investors.

Hertzog says that the search for yield is driven by savers finding that the interest earned on bank deposits is lower than the prevailing inflation rate. “With interest rates currently at record lows in many markets, savers in numerous countries are finding that the interest rate earned on bank deposits is lower than the prevailing inflation rate.

“Due to behavioural reasons, many savers are reluctant to finance consumption out of capital.  This state of affairs is also creating a very strong, but in our opinion very dangerous, incentive – namely to ‘reach for yield’.”

He says that in an effort to generate sufficient yield from investments, investors are taking on too much risk. “Whether this takes the form of credit, interest rate or business/equity risk varies from case to case. What doesn’t vary is that the level of risk being assumed isn’t proportionate to the level of return on offer.”

Hertzog explains that the old adage of ‘consume income, not capital’ is a dangerous rule of thumb if followed blindly. “While the rule may have served investors well in the past, we fear that it is currently having two very negative effects. Firstly, those investors who stick to the traditional income-generating investment options are being forced into gradually lowering their standard of living in an effort to make ends meet from their income. Secondly, those who wish to maintain their standard of living while not spending their capital are taking on undue risk in an effort to do so.”

He says that investors who wish to maintain their standard of living but don’t want to take on undue risk in the process need to accept that the widely held distinction between income and capital is a fallacy.

“The rate of expenditure that a given investment can sustain depends on the total return generated by the investment over time, not whether the return is being earned in the form of income payments or capital appreciation. Once investors have accepted this fact, they are in a far better position to allocate capital sensibly and in accordance with their needs than if they try to adhere to the ‘spend income, not capital’ mantra.

“Investing with the goal of generating the best total return over time, within the constraints of a given risk profile, is a far superior way of allocating one’s capital than to invest solely for income (or, for that matter, solely for capital growth). Determining what the best vehicle is for generating these risk-adjusted returns should be the primary consideration in any investor’s mind, not whether the returns are being earned in the form of income or capital growth.”

Hertzog says that investors who have expenditure needs greater than the income payments provided by their chosen investment vehicle can generate the cash required by selling part of their investment as the need arises. “While this may feel to many investors as if they are ‘eating their seed corn’, the truth is that by following this strategy an investor is actually sowing the seeds for a bountiful future. In addition, selling a portion of an investment is typically a far more tax efficient way of generating cash flow from an investment than to earn interest (or, depending on the tax jurisdiction, dividends) from that investment.”

He says that data suggests that the odds massively favour those investors who can cross the emotional bridge of looking at capital as sacred and income as something to be spent. “The reckless thing to do is to buy expensive assets that offer some yield as an illusory means of avoiding the consumption of capital,” concludes Hertzog.

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The Allan Gray-Orbis Global Equity Feeder Fund remains fully invested in global equities. The objective of the Fund is to outperform the FTSE World Index at no greater-than average risk of loss in its sector.