Growth vs. Income Investing

If you took a survey and asked multiple people what kind of investor they are, you’d likely get a wide range of answers.

You might hear things like, “I buy mutual funds, stocks, bonds, real estate, private placements, venture capital,” etc. Others might identify as active or passive, risk-averse, or involved with high-risk asset classes. There is almost no end to how someone might recognize. 

But, if you ask them what their financial goal is for their investments, it typically comes down to one or more of these three things:

• Safety
• Capital Growth
• Income

These goals are so important to investors that a simple Google search will yield countless articles on investment safety and growth vs income investing. Given the importance of these three goals, let’s take a deeper dive into each.

Safety

Let’s be clear: there is no such thing as a 100% safe investment. All investments have risk, but they don’t all have the same risk. 

Now, some people claim that U.S. Treasury Bills are risk-free because the U.S. government backs them with its full faith and credit. They say the government’s likelihood of defaulting on its obligations is nil. 

However, as of this writing, the U.S. Government is more than $31 Trillion in debt and climbing. In 2018, the national debt was roughly $21.5 Trillion. Both the rate and rise of this expansion should give one pause in thinking that the government will always be solvent.

But let’s get back to risk. It’s helpful to consider it in terms of a risk/reward spectrum when considering it. 

If you invest in riskier asset classes, then the potential reward should be commensurate in scale. Investing in riskier assets with returns that are less than or equal to less risky assets makes no sense. 

For example, let me share the risk/reward spectrum in real estate investment strategies.

Risk/Reward Spectrum In Real Estate

• Core
  • Top-tier locations and high-quality tenants
  • Lower risk
  • Return expectation 7% – 10%
• Core Plus
  • High-quality tenants with second-tier locations
  • Low to moderate risk
  • Return expectations of 8% – 11%
• Value Add
  • Higher upside
  • Considerable capital needs
  • Moderate risk
  • Return expectations of 11% – 14%
• Opportunistic
  • Ground up development
  • High debt
  • High risk
  • Return expectations 15+%

As you move from core to Optimistic investment strategies, the risk increases, and so does the potential return. It’s important to match an investment’s risk-return profile with your risk tolerance, age, and timelines for investing and retirement.

In general, many financial advisors believe that young investors can tolerate more risk, but that risk should be ratcheted back incrementally as they age and approach retirement.

How to Measure Risk

When it comes to investing, you’ll encounter five risk measures. You can use one or more of these measures to assess risk. Just be sure to use the same measure(s) in your comparison so it’s an apples-to-apples assessment.

Alpha

Alpha measures the difference between an investment return and a broad benchmark. So, if we’re talking about a stock market investment, it might be compared to an index like the S&P 500.

If you owned two investments that returned 12% and 6% in a year in which the S&P 500 returned 10%, then the alpha would be +2 and -4, respectively.

Beta

Beta, like Alpha, is most commonly encountered with stock market investments. It measures volatility and compares an asset’s volatility to a benchmark index like the S&P 500.

Beta is at baseline when it is equal to 1. One means that the investment’s volatility is equal to the market. Above 1 means that the investment is more volatile than the market. Below 1 means that it’s less volatile. Consequently, a Beta of 1.6 is 60% more volatile than the market, and a Beta of 0.5 is 50% less volatile than the market.

R-Squared

R-Squared measures the correlation of an investment to its associated benchmark. In other words, it looks at how much of an investment’s movement is related to the benchmark’s movement. 

The S&P 500 is typically employed as the benchmark for equities, while The U.S. Treasury Bill is used for fixed-income securities.

An R-Squared of 90 would be highly correlated to the benchmark while another of 30 would be considered to have a low correlation.

Standard Deviation

Standard Deviation is a measurement of volatility. It looks at the spread of prices and how much they vary from the mean. The larger the standard deviation, the more volatile and unpredictable the prices. 

High standard deviations indicate riskier investments than lower ones. 

Sharpe Ratio

The Sharpe Ratio is the risk-adjusted return. It compares an investment’s performance to the risk-free return (typically government T-Bills) after adjusting for risk. The higher the Sharpe Ratio, the better. When comparing two assets, the one with the higher Sharpe Ratio provides better returns for the same degree of risk.

The Sharpe Ratio and standard deviation are used across multiple asset classes. These are the two measurements typically seen when evaluating commercial real estate. I’ve written about the standard deviation and Sharpe Ratio numerous times, most notably in the article: How Would a Recession Affect Multifamily Investing?

The bottom line is that historically, multifamily real estate has had one of the lowest standard deviations and highest Sharpe Ratios compared to the other real estate asset classes, the S&P 500, and various bond indices.

Growth vs. Income Investing – Growth

Capital growth or capital gains investing is when one invests to grow the value of their initial capital investment. These investors emphasize portfolio appreciation over current income. 

Don’t confuse capital growth as an investment goal with growth stocks or funds. Within the market, some people will talk about growth funds (stocks) and value funds (stocks). Both growth and value stocks have the same investment goal of capital appreciation. These terms reference the risk/reward spectrum of the stock market.

• Growth Stocks/Funds
  • Aggressive, high-risk, market-based investments
  • Investments in young, rapidly growing companies & startups
  • Potential for higher returns
  • Typically, they do not pay income dividends
• Value Stocks/Funds
  • Less aggressive
  • Investments in established, more stable companies
  • Less (medium-high) risk
  • Often pay income dividends in addition to capital gains

Financial advisors are most likely to recommend a higher concentration of growth investments (both growth and value) in the early years of one’s working life. And as the years pass and one gets closer to retirement, their advice gravitates away from growth investments and toward less risky income investments. 

This is the theory behind target-date funds, which can be graphically represented below.

Source: T. Rowe Price

Growth vs. Income Investing – Income

Income investing involves building a portfolio of assets that produce passive income. The goal is to maximize one’s income while consistently producing that income over time. 

Some income-generating options are real estate investments, dividend stocks (blue-chip stocks and others), bonds, royalties, certificates of deposit, and money market accounts.

The closer one gets to retirement, the less tolerable high-risk investments become. Significant dips in the value of one’s portfolio can leave one working well past the time they targeted for retirement. When one retires, their primary source of income (their job) ceases to exist. That’s why many people gravitate to alternative sources of income that aren’t dependent upon their labor.

The more stable those sources of income are, the better off the individual is.

Why Real Estate Presents Opportunities for Growth Investors and Income Investors

Growth vs. Income Investing is a debate that has been going on for decades. But there are merits to both. And if one can achieve solid returns in both growth and income, why wouldn’t they? 

Furthermore, if they can achieve those results in an investment with less risk than most, then they’ve found an investment that matches the trinity of investment goals—safety, growth, and income.

That investment is multifamily real estate. 

As discussed earlier, multifamily real estate has historically had a high Sharpe Ratio and low Standard Deviation. It’s been an investment that has provided stock-like returns while maintaining a low-risk profile.

Growth occurs in this asset class from increasing net operating income (NOI). Increasing rents, decreasing expenses, and improving renter retention increase NOI. This is forced appreciation, which grows investor’s equity.

Also, income can be generated simply by purchasing properties whose rents exceed their expenses, allowing income to be distributed regularly.