December 25, 2013 Craig Adeyanju Follow me on Twitter here.

Regardless of the investment vehicle that’s chosen, there are only two types of investors.

1. Those who invest their assets for capital gains
2. Those who invest in cash flow (they’re after income-generating assets).

In theory, there isn’t much difference between these two, thereby in part, obeying The Modigliani–Miller theorem of indifference. However, in reality, things turn out differently. In here, we’ll try to spell the differences between these types of investing with respect to the returns investors get.

Optimizing for total return

Let’s face it, whenever we invest, we do so with the aim of optimizing total return. And theoretically, this strategy of optimizing total returns has been proven to have the highest safe withdrawal rate – or SWRs. Of the two types of investments we’re dealing with here, capital gains investing seem to present investors with higher SWRs.

Some researchers have demonstrated. by setting up two inflation-adjusted portfolios that are geared toward these two types of investing, that a total-return – or capital gains – portfolio supports a 4% plus annual SWR over a period of 30 years. On the other hand, an income-oriented portfolio – cash flow investing – has been found to support only about 3% annual SWR, provided that both portfolios are exposed to the same level of risk.

A recent paper by Geoff Considine. the developer of Quantext Portfolio Planner confirms that a total-return portfolio promises a higher SWR. His findings are summarized in the table below.

Source: Advisor Perspectives

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Realizing maximum returns

Another argument is that capital gains investing present investors with higher odds of realizing the maximum ROI possible. For instance, in the case of stocks, some believe that dividend yield is only one of several metrics that can be used to judge the viability of a stock, which is true.

Thereby, suggesting that income investing is a subset of value investing. Considine’s findings from the above table also supports the argument of higher ROI with capital gains investing; the portfolio expected return in the Maximum Expected Return Portfolio is higher than in the Maximum Yield Portfolio.

Estimation Risk

However, we need to consider one factor – estimation risk. The entire argument of ‘cash flow investing isn’t superior to capital gains’ is driven by a somewhat higher estimation risk than in cash flow investing.

While investing is about getting the maximum return possible, looking for options that present healthy returns with the minimum risk possible is equally important. Here is where cash flow investing comes back into the picture.

The lower risk that comes with cash flow investing is made obvious is how each of these types of investing respond to the economy. As I said in a previous article ,

Even during the great recession, dividends understandably fell 23%, but that’s just about half the total fall of the entire market.

That’s an indication that income-generating assets fair better than total return assets when the macro-economy is struggling.

Thinking about inflation

Another way to understand this is by thinking about inflation, which reduces your purchasing power. If you have your money tied in tangible assets like real estate – an income-generator – inflation can’t have a direct effect on what you receive on your property. No matter the kind of recession, people will need a shelter.

So you’d always get an income from there. It can only affect what you use the income for, the part that affects everything. Moreover, you do not need to time the market when investing for cash flow as you would in the case of capital gains investing.

Bottom line

Just as Modigliani and Miller said, it shouldn’t make any difference to investors whether they get their returns inform of stipulated returns – dividends et al. – or capital gains. The reason you’re investing is what should determine which one you go for.

For older people who’re planning toward a specific number of years after retirement. where an assurance of steady income is essential, it’s safer to invest for cash flow.

As we’ve seen above, the chances that you will overestimate what you are going to receive in return is lower here, hence, making cash flow investing more bankable. Capital appreciation on the other hand, is suitable for younger people who are after wealth creation.

However, in order not to overweigh either of the two categories of investment, there is a room to diversify across board. The third category in Considine’s research from the above image shows that you can reach a compromise between the two types of investment without necessarily limiting what you receive in return.

The truth is most of the facts we have are drawn from what happened in the past. Even those that talk about the future are drawn from the past. So in reality, no research is absolute.

Therefore, to cut down the risk of failing on either side, you should consider investing for both capital gains and cash flow. But then, you will need to allocate assets from both categories in accordance to your risk tolerance.

P.S. Whichever type of investor you plan on becoming, it is critical that you always do your homework before making the investment. A good place to start is by clicking on this link