While safety, managing investment risk to protect a portfolio from loss, is probably the most important aspect of asset management, growth of capital and cash flow also play an important role. Different types of assets have different levels of average returns, and, in general, high returns equate to high risk. So, investors must take into consideration how safe they want their investments to be while balancing the return on investment they would like to receive.
Managing Rate of Return on Investments
Rates of return on investments are generally considered to come in two categories: growth and cash flow.
Investing for Growth
Some assets have growth but no cash flow – for example, a biotech stock that increases in value by 20% in a year but pays no dividend would provide growth, but no cash flow. An investor who owned it would be 20% richer at the end of the year but have no cash in their pocket.
Investing for Growth and Cash Flow
Some assets offer both cash flow and growth, in varying degrees. The more of one they have, the less of the other. Growth-focused assets would be expected to have higher average returns than income-focused ones, and also have higher risk.
The S&P 500 index fund SPY, for example, has a long-term average total rate of return of about 10%. This is made up of, on average, about a 7% increase in value and 3% in dividends. In recent years, it has skewed more like 8% growth and 2% dividends.
The Utilities ETF, called XLU, has had about a 7.2% average total return over its 20-year lifetime to date. This has been split almost exactly half and half between price growth and dividends.
Investing for Cash Flow
Some assets have cash flow, but no growth.
For example, the exchange-traded fund called PFF is a collection of dividend-paying preferred stocks. It closed at $37.15 per share today. Eleven years ago, in July 2008, it was at exactly the same price, $37.15. It has had zero growth in value in eleven years. We should note that that does not mean that the price has never budged. In fact, over that period the share price has ranged from $50 a share at inception, down to $14 in the financial crisis, and back up to $37 now. Through thick and thin, it has continued to pay its dividends, paying out $29.74 per share in total dividends. Its net annual return for its diehard buy-and-holders has averaged 5.5%, all of it in the form of cash dividends.
A similar example is the REIT called AGNC. Since its inception in April 2008, AGNC’s share price has dropped from $19.50 to $16.82, touching a high of over $36 and a low of $12 along the way. But for all that time, it paid high dividends, for a long-term average rate of return of over 10% per year, after considering the drop in the share price. At current prices it was recently yielding over 11% annually.
Dividend vs. Non-dividend Stock
As an economist and accountant, my point of view is that the separation of growth and income, common among investment advisors, is not really valid. Cash flow that is reinvested becomes growth of principal, while growth of principal that is partially harvested becomes cash flow.
If I start with stock worth $100,000, and the stock pays dividends of $5,000, and at the end of the year the stock is still worth $100,000, I’ve had a 5% increase in my net worth. $100,000 in stock plus $5,000 in cash from the dividends equals $105,000, a 5% increase.
On the other hand, if I start with a different stock worth $100,000, and the stock pays no dividends, but at the end of the year the stock is worth $105,000, I’ve had a 5% increase in my net worth. $105,000 in stock is a 5% increase. If I want that 5% in cash, I can sell $5,000 worth of shares and end up with $100,000 in stock and $5,000 in cash, identical to the other case.
This equivalence, by the way, is why dividends are not taxed as ordinary income. They are taxed at capital gains rates (unless the dividends are from REITS, which pay no corporate income tax. Their dividends are taxed at ordinary income rates.)
For some investors, the two example investments above are not equally attractive. For example, if know that I need to withdraw and spend the $5,000 every year, rather than letting it accumulate, then I am better off with the dividend-paying stock. Although its return is the same in the long run, in the short run I want to know that the cash is coming in, without relying on selling shares that might or might not have gone up in a given year.
Someone else, who is many years from retirement and needs no cash flow now, might not want to be bothered with constantly reinvesting small dividend payments. It would make more sense for that person to use the non-dividend stock.
When evaluating investments, consider whether their total return characteristics match your investment goals. Consider whether you prefer skewing your returns toward current cash flow or toward growth of principal. For most people, it will make sense to include a mix of both types.
Read the original article here - Choosing Between Growth Investments and Income Investments