Inside your investment portfolio there are two components to investment growth: cash flow (or income) and capital appreciation. Your cash flow return is what you receive each year in the form of dividends and interest. The return from capital appreciation comes from increases in the market price of your investments over time. Together, these two sources of returns are known as “total return”.
One issue that I’ve encountered is that many people tend to favor the cash flow component and disfavor the capital appreciation component of total return. This is often embodied in the old saying, “never touch the principal.”
Consider Roger, a retiree who is trying to determine the best stock fund to invest in. If Roger invests $1,000,000 in the S&P 500 with a yield of 1.5%, he can expect to receive $15,000 of income each year. But if Roger invested that $1,000,000 in a high dividend stock fund with a yield of 3.0%, he can expect income of $30,000 each year. Is Roger better off with the higher income fund?
Don’t second guess the market
If Roger wanted to follow the “never touch the principal” ethos, he will likely choose the higher cash flow investment, which provides more money to spend each year. However, high cash flow investments don’t guarantee better investing outcomes. In fact, there is a solid possibility that, by focusing on high cash flow investments, Roger could suffer lower total returns over time.
To illuminate this further, let’s go back to the core foundation of passive investing. Namely that financial markets are highly efficient. Put another way… the average investor cannot outperform the market. This isn’t my opinion either. Just read William Sharpe’s seminal article, The Arithmetic of Active Management. Sharpe proves, using basic math, that all investors will collectively match the performance of the market.
Add in investment costs and fees, and investors will collectively underperform market by the amount of those costs and fees. That’s one reason why I always make a big deal out of costs and fees.
If we believe that the average investor can’t beat the market, then why should we favor investments with high cash flow over those with high capital appreciation? We shouldn’t. Our main focus should be on trying to gather the average total return of the broad market, not just the income returns. And often when we try to second guess the collective wisdom of markets, we end up “eating crow”.
What about taxes?
It’s safe to say that investments which pay out high levels of income are tax inefficient. That’s why most advisors recommend locating high income assets (e.g. bonds) in your IRA. Many tax planning opportunities rely on an investor’s flexibility around the timing of income recognition. But, all else equal, investing for high income reduces that flexibility.
As an example, look at Warren Buffett’s approach at Berkshire Hathaway. He famously (or notoriously) refuses to pay a dividend and instead relies solely on buybacks to return cash to investors. This does a couple things. First, it allows the world’s greatest investor to do what he does best, allocate capital. As Berkshire’s businesses generate cash, Buffett can survey the landscape of investment opportunities and allocate capital to the best one available. For example, if Buffett sees a great available investment opportunity, he doesn’t need to forgo it simply to meet the requirements of an upcoming cash dividend to shareholders.
Second, buybacks give Buffett the flexibility around the timing of shareholder capital returns. Simply put, when Buffett deems that shares of Berkshire Hathaway are priced at a discount to intrinsic value, he can go into the market and buy them. If the shares are priced above intrinsic value, he does nothing1. This stands in contrast to dividends, which generally return capital to shareholders on a fixed schedule that doesn’t account for the price-to-value relationship.
Buffett’s approach to buybacks gives his shareholders the full authority around timing of their own investment income and can often help reduce the tax drag in their portfolios. For example, if a Berkshire investor needs cash, they can sell their shares whenever they want, rather than rely on a fixed dividend schedule. This provides Berkshire investors with an extraordinary ability to defer taxable investment income to the years when it is most advantageous to recognize it.
Safety for principal?
Some people might say, “Well, if I don’t touch the principal and only spend the cash flow, I will never run out of money.” And that sorta makes sense. If you only spend the cash that comes into your portfolio then theoretically your portfolio principal can remain untouched to allow for growth over time. However, there is no free lunch… in many cases if an investor is choosing to invest for higher income payments to justify additional lifestyle spending, then it could result in a lower portfolio value down the road.
You could also argue that investing for higher cash flow can lead you to miss out on investing in some great companies simply because they don’t pay a dividend. Think about technology companies (or even Berkshire Hathaway). Many of these companies don’t pay dividends or return capital to shareholders because they have high quality investment opportunities within the company. In fact, the managers of any company with a truly phenomenal business would be stupid to pay a dividend simply because they would likely have to forgo reinvesting that capital into growing their business.
And at the end of the day, is there actually any difference between a dollar received from dividends vs. a dollar received from capital appreciation? Not really! Money is fungible and if each dollar is the same, then it follows that we should not give a fig whether that dollar reaches our pocket via capital appreciation or income. Our main goal should be to find the best investment opportunities available for every dollar that we have.
So when it comes to investing, consider taking a total return approach. Try not to focus too much on the dividend/interest income generated by your portfolio, but rather aim to craft a high-quality, passive, and low-cost portfolio that can deliver an adequate total return over a long period of time. Let the markets worry about whether your returns come in the form of income or capital appreciation.
1 It’s important to note that stock buybacks can also subtract value for shareholders. To do it right, company management should only execute buybacks when they can buy shares at a discount to intrinsic value. Many companies do not do this, they just blindly buy back shares whenever they feel like it in order to juice earnings per share results in the near term. Warren Buffett talks extensively about the folly of buybacks in his investor letters.
