Water Level At the Dock After A Single Night's Rain. I've Written About This Before. It's a relatively simple concept, yet I am surprised at how few people have a firm grasp on how we are rewarded for risking our capital in an investment. I even find financial professionals who do not have a firm understanding. There are two major sources for our return. 1. Benefits (usually in the form of cash) during the holding period. 2. Benefits from selling at a profit at the end of the holding period. If I told this to an audience at a seminar, I would expect to hear a chorus of "Duh" after those statements. While you may hear a few other suggested benefits such as tax advantages, etc. the first two overshadow the remainder. Here is another Duh statement.
More Is Better Than Less and Sooner is Better Than Later. Again relatively simple; however, there are some strong implications here. It's a relatively simple matter to understand that the sooner you begin to receive cash flow, the lower your risk. Less obvious is the fact that this interim cash flow may be a return on investment or it may be a return of your initial investment. Also, you won't really know which it is until the end of the holding period. To use a real life example from my own portfolio, consider an investment I made in a company called Prospect Energy Capital. My original investment was in May of 2007 when I bought 2000 shares at an average price of 13.50 per share. During this holding period, I have received distributions of $9685. Not a bad return on an investment of $27,000. That is until you look at the current value in todays market. At a current price of $9.45 the value is $18.900 or $8,100 less than I paid. From that point of view, if I sold today, my $9685 in distributions would be considered as a return on investment of $1585 and a return of capital of $8,100. If you have trouble following this example, let me assure you it's relatively simple. Your failure to grasp this concept was more likely do to boredom or not giving a damn. For some reason I enjoy this sort of thing.
Let's Go A Step Further. Suppose I sold today what would be my return on investment. Let's simplify this and say I received my distributions monthly (which I do at present.) My return would be an average of 193 per month for 50 months. This equates to an annual return of 1.61%. Obviously, there is little argument that if I sold today this would be a poor investment. Let's say we didn't receive those distributions and we sold today at $28,585 (current value of $18,900 plus $9685). Our return on investment would be 1.37%. While this is not a huge difference, it does illustrate my point. More is better than less and sooner is better than later.
An Even More Important Point. It isn't just the magnitude of your return that matters it's which is the most important to you. In a high risk environment such as this one. Current income is important as a risk reduction tool. I have clients tell me that they have an adequate income from salary to fulfill their income needs. This can be true for many of the younger folks with relatively stable employment but one point to remember is that current income is important for things other than income to fund your lifestyle. It can be valuable for reinvestment. During the "Tech Wreck" when dividends were considered less useful, many ended up with a drastically reduced portfolio value with no capital to re-invest in stocks at bargain prices.
So Who Would Benefit From Later Rather Than Sooner Income? As I mentioned before, one group that would often choose growth would be higher tax bracket investors with no need for income to fund their current lifestyle. Since there is no current tax on accumulated growth, these are much more tax efficient than stocks with current income. Also, stocks that reinvest their earnings rather than pay distributions should be able to earn more on this capital than the investor who must reinvest these funds. Unfortunately this isn't always the case as some companies can't be depended on to invest this capital in the best interest of shareholders as opposed to management.
The Implications of All This. Some of us have no interest in finance for different reasons such as the lack of capital to invest or the ability to make more money doing something else while they pay to have their investments managed. My position is, whether you manage your own money or have someone else do it, the more knowledgeable you are the better qualified you are to communicate your needs to your investment manager or spot a manager who is acting more in his best interest than yours. I would appreciate your feedback on this post.
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