Not all Returns are Equal

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As the financial year chugs along, we think this is a good time to remind our readers that investment rewards come in many shapes and sizes – and some may suit your needs more than others.

In very simple terms, when you make an investment, you are doing one of three things with your money: (i) buying property, (ii) buying ownership in a profit-seeking business, or (iii) lending your money to someone else. In terms of (i) and (ii), you may not be buying the whole property or the whole business, and all three types of investment can be made indirectly, for example through a super fund or a fund manager. But, at base, these are the three varieties of investment available to most of us.

The rewards from investments are known as ‘returns.’ Returns can come in two broad types: (a) income return, which is the return you receive while you continue to hold an investment; and (b) capital return, which is the return you receive when you stop owning the investment.

To give an example of each: if you buy an investment property, then you receive rent while you continue to hold the property. Rent is the income return. When you sell the property, the difference between what you bought it for and what you sell it for is the capital return. If prices have risen, you will make a capital gain. (If prices fall, that’s a capital loss unfortunately).

If you buy shares in a company, then you receive dividends while you own the shares – assuming that the company makes profits and decides to pay those profits out to shareholders (two things that do not always happen!) When you sell some or all of the shares, once again the difference between the price you paid and the price you sold at is the capital return. If prices have risen, you will make a capital gain (or, once again, a loss if prices fall).

If you lend money to someone, things can be a little different. You receive interest on the investment and this interest is your income return. You usually then receive your money back when the loan period ends. In this way, relatively few loan-type investments provide a capital return. (There is an exception – which is where someone else buys the loan off you without the borrower repaying the loan. This can happen, for example, if you sell a bond).

If you are thinking about making an investment, then it really pays to understand what type of return you most want to achieve. Different investments tend to have a different ‘mix’ of potential capital and income return. Residential property, for example, tends to have relatively low income returns and (if all goes well) relatively higher capital returns than commercial property, for example. So, a person who really wants to invest in property needs to think about whether they want to receive more return while they hold the investment or whether they would be better off deferring more of the return to some future date. If they like property but need income in the short to medium term, commercial property might make more sense.

In the coming weeks, we will be running a bit of an ‘investment intensive’ where we look at each of the three different types of investment and discuss common ways that investors can access each of these kinds of investment. We will also look at things like the ways in which the different types of return can give rise to different taxes being payable (and how this can affect the total return that you receive). So, please watch this space and we hope that our series makes you a more informed and confident investor.

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