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.