Capital gains vs income, and living within your means

Something’s been on my mind quite a bit recently, and I realise I don’t read much about it. At it’s simplest, it’s how to think about my portfolio’s income versus capital gains.

What I think I know about Capital gains vs Income

I have always liked Income.  I see it as something which is hard to fake; it is closely related to a company’s cashflow, not some mumbo jump Snapchat-like handwavey numbers.  If a company increases its dividend from 50p/share to 55p/share that tells me quite a bit about its profitability and prospects; if a company share price rises from £10 to £11 that tells me next-to-nothing about the company’s performance or prospects.

About two thirds of a portfolio’s long-term return comes from reinvesting Income.  This makes Income sound like the clear winner in the comic strip Income Vs Capital Gains.  But of course by implication if a company hadn’t distributed its Income but had invested it itself then in theory those same gains may have occurred.  Certainly some of the best long-term performances have come from US companies that deliberately don’t pay out any Income – e.g. tech stocks like Google, Amazon, Facebook, as well as Warren Buffett’s Berkshire Hathaway and many others.

Taxpayers prefer Capital Gains.  In the UK these days higher rate taxpayers pay investment Capital Gains of only 20%, whereas Income taxes top out at 45% (even higher. The annual allowances are quite similar at about £10k each. In theory somebody with a large (>£2m) taxable portfolio, generating returns of say £100k+ per year, this makes Capital Gains a far better way to receive that return than Income.  The USA makes Capital Gains even more favourable, in most states, which somewhat explains why US companies are less likely to pay dividends than UK ones and when they do they typically pay out lower distributions.

Capital Gains are somewhat easier to optimise, by judicious timing of sales.  In particular one can sell assets at a loss to reduce the liability from big gains.  One can also sell just enough to make full use of the personal allowance; Income is harder to do this with.

What I don’t understand about Income vs Capital Gains

There are plenty who argue Capital Gains’ tax advantages make it always better to take returns by selling shares rather than from dividends. If I had 1m Glaxo shares then I understand this argument.  But at an intuitive level I struggle with it.  My mental model of a stock market company is of a farm producing crops, or of a buy-to-let producing rental income . The idea that rather than sell the crops I should sell a piece of acreage, or perhaps a window or two of the buy-to-let, leaves me recoiling.   When I’m down to my last Glaxo share, what do I do next – not such an idle question in the case of Berkshire Hathaway’s $265k/share stock?

I also don’t understand how to budget for Capital Gains.  Ultimately my portfolio will provide for my spending.  Matching spending to income is a very obvious and intuitive thing to do.  Those who favour capital gains often argue for keeping perhaps 1 years’ cash at hand, and topping it up every year (via selling assets), but some cognitive shortcoming in me finds this approach unappealing. Why do I resist this approach? It it because I know that somehow when I have big balances my spending goes up?  Is it because I am OCD about tracking monthly income and would get bored tracking CGT? Is it because share prices are inherently more volatile than income is?

I know both empirically and instinctively how much annual income my portfolio generates.  But I don’t really know how to judge its annual capital gains capacity.  Yes the dividend cover is about 2 and so roughly there should be approximately equal capital gains each year to its income.  But is it that simple?

Do I have a £50k problem?

So far, so abstract.  But in the here and now I find myself looking at the rapidly increasing value of my portfolio and I’m not sure how to handle it.  Right now I spend more than my income, for a couple of reasons. Let’s say I’ve overspent by £50k, for argument’s sake. This figure is made up but just imagine I had bought a new car, indulged my wider family with a generous summer foreign holiday, made a couple of chunky charitable contributions, and you’ll get the idea.  Generally I would wince at the prospect of spending more than my income.  And £50k is a serious delta.  So why aren’t I wincing deeply?

The truth is I don’t really know how to think about an overspend of £50k. After twelve months where my portfolio has gone up in value by around £1m, with underlying returns of about 30%, far more than my income, if I sell say £50k and ‘waste it’, is this just ‘easy come and easy go’? Perhaps this gain is basically an unexpected windfall?  Or is this 12 month gain a relatively predictable episode among many, some of which will be -30%, and which on average deliver say 5%+inflation long-term sustainable returns; in this case then my reducing my portfolio in its best period I’m probably diluting my long-term returns.

On the other hand if I consider £50k to be less than 5% of last year’s increase in my net worth, then what on earth is there to worry about?  To the extent that I can’t really help myself, or that I have started to buy forbidden fruits which I will become addicted to, then I clearly may have a problem – especially in a year when my net worth drops by £1m. Foreign travel is definitely a luxury I spend a lot on and would struggle to curtail completely; on the other hand fine dining is something I can spend plenty on but don’t think I’d miss too much if austerity demanded it. The upkeep of my Dream Home and its garden are fast becoming a significant cost – is this ‘capital investment’ or just wasteful frittering?

In the meantime my Investment Philosophy tells me to stick to my target allocation. Right now this means selling US equities and repaying some of my portfolio loan.  This conclusion definitely makes sense to me and I am doing it.  But as with St. Augustine’s wayward prayer, I am going about it in my own sweet time; this heel-dragging has left me overweight on equities and overleveraged and this has played out nicely in the Trump boom.    But this is not disciplined investment behaviour.

In the meantime I am wondering how I will fare if the market takes one of its periodic 25-50% tumbles.  Intellectually I am prepared for it.  But emotionally I know my mood will be sour, my relationships will suffer, my charity giving will drop and my confidence will droop.  And if I can’t be disciplined about spending within my means, rebalancing to my target allocation etc when the times are self-evidently good do I have any business with my investment hobbies after all?

As you can see I don’t have much structure or clarity about these thoughts.  I am slightly drifting without a rudder or an anchor, letting the favourable currents do their work.  But I know it would be better to have a rudder and an anchor.

Any offers of help would be very welcome.

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8 Comments on “Capital gains vs income, and living within your means”

  1. grasmi says:

    I have been grappling somewhat with this too. In the past my decisions on the tilt between income vs capital appreciation have largely been driven by my current tax jurisdiction. Currently I’m in Switzerland – a 0% CGT rate does a lot to incentivise you to try and steer towards growth rather than income! BRK is another one of my holdings for the very same reason (you can pick up the more manageable BRK.B’s for the princely sum of $175 – they’re identical to the A class shares, just a tiny fraction of one – so a bit easier to manage!). But with all that said, I still end up drifting at times back towards income (I am roughly 40% allocated to Australian equities which are generally high yielding). Logically I know it’s hurting me from an after tax perspective, but as discussed previously I like Australian equities for other reasons (100 year returns, selling at a heavy discount due to commodity supercycle, etc). I also find it difficult to buy into individual growth stocks – I struggle buying stocks with stratospheric PE and a difficult and subjective to value business! I definitely give the taxation situation a weighting when making decisions, but probably not as much as I should. A lot of this comes down to the fact that growth stocks conflict with my normal style – I typically look for solid companies with a decent track record and strong management that are going through a transitory (and hopefully not terminal) rough patch. At day end, I still need to be comfortable with the trade – there’s no point saving 30% tax if you go outside your comfort zone and end up with a loss!

    Sorry – not much help to you, but you’re not alone!

    Cheers,

    Graeme

    Liked by 1 person

  2. John says:

    Your rudder or anchor must be your financial objectives, what you actually want your money to allow you to do.

    There are no prizes for having the largest portfolio, the highest investment returns, the greatest investment policy statement, the least deviation from a tactical allocation, the least tax paid. And if there were, you wouldn’t win them. And if you could win them, you’ve got your priorities wrong.

    All that really matters is if your investments allow you to spend what you want to spend and give away what you want to give away. It would be interesting to hear more about what that means to you.

    But if that includes spending £50,000 of capital on whatever (and also spending the income) and that is very unlikely to compromise the rest of it (seems pretty unlikely in a multi-million portfolio), then why think twice about it?

    The same for rebalancing, repaying the margin loan, income versus capital gains – you’ve worked out the right thing to do, less thought needed, more action. Classic analysis paralysis.

    Investing can be a hobby, and yes of course you want to optimise your tactics, but you need to keep sight of the bigger picture.

    Recent returns are just part of a series of returns, some good, some bad. And measured in currencies besides sterling, the windfall is not so great after all.

    Though if anything, withdrawing while many markets are at record highs is far less likely to inflict any serious damage on what you might achieve over the long term than doing the same after market dips.

    Liked by 1 person

  3. Slow Dad says:

    Intriguing questions their FVL. I think you may be overthinking things a bit.

    I share your instinctive view on recurring income versus a one-off asset sale.

    I think it comes back to a philosophical question: would you prefer a (potentially) infinitely renewable stream of wealth, or a finite bucket of wealth? Unless the bucket was ridiculously large, the stream should win for most people.

    To me the tax question is a bit of a red herring. If you’re paying tax, you are making money (in theory). While paying tax sucks pretty hard, it likely means you are doing something right.

    The fact that capital gains are more favourably taxed doesn’t make them inherently better, just that the lobbyists representing folks who like making gains were more effective than those espousing dividends (or rent or interest or royalties).

    Also don’t forget the tax system is often (mis)used to execute social policy, or be seen to be doing something about a given hot topic… just look at how recent budgets have left buy-to-let landlords and freelancers as feeling like they have been screwed with their trousers on.

    On a recent holiday in Cuba (how’s that for a humble brag?) I read the Alice Schroeder’s book about Warren Buffett. One of the themes it espoused was Buffett buys investments “forever”. Unless the fundamentals of the asset significantly go down the toilet, they would need to prised out of his cold dead hands. He’s a pretty smart bloke, Warren. Likes investments that generate loads of income. The reason he doesn’t distribute dividends is in large part because he reckons his shareholders wouldn’t use them as productively as he can.

    So consider this analogy if you will. If you’ve got a milking cow, you have milk to put on your Cheerios for term of the cow’s natural life.

    Tasty though a steak dinner may be, the morning after it has been enjoyed your breakfast will be somewhat crunchy.

    As it will the next day.

    And the next…

    After a while choking down dry Cheerios is going to get pretty old.

    For mine I like milk on my breakfast cereal, regardless of what the tax man has to say on the matter.

    Like

  4. The Rhino says:

    hmm – if income is salary plus rent received say then why not just add on 4% of remaining portfolio value (i.e. not inc. primary residence and rental properties)

    if once you’ve done that you are in surplus or break even then all fine

    if that results in a deficit (assuming its not an obvious one off expense thats done it) then its time to dial back expenses

    pretty simplistic but might be a useful starting point?

    Liked by 1 person

  5. […] Capital gains Vs income Vs living within your means – Fire V London […]

    Liked by 1 person

  6. david m says:

    I would have thought you could spend your employment income plus your investment income each year if you wish. It would appear that your £50,000 is likely to be less than a half or a third of your investment income. Of course at some point you will only have the investment income and the critical question will be whether that exceeds your spending then.

    If your total spend this year was less than your investment income then all is fine.

    Liked by 1 person

  7. […] (not very SMART, basically) so I’m not yet ready to assess it. I’ve been musing over how best to think about spending proceeds from selling stock market gains, without reaching a firm conclusion.  Yes, you guessed it – I’ve been overspending and […]

    Like


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