The bird-in-hand theory suggests that investors prefer dividends from stock investments over potential capital gains due to the inherent uncertainty of the latter. This concept is best encapsulated by the saying, “A bird in the hand is worth two in the bush.” Investors find the certainty of dividend payments more appealing compared to the possibility of larger, yet uncertain, future capital gains.
Key Takeaways
- The bird-in-hand theory indicates that investors favor stock dividends because of the unpredictability associated with capital gains.
- This theory emerged as a counterargument to the Modigliani-Miller dividend irrelevance theory, which claims investors do not prioritize the source of their returns.
- In investment terms, capital gains are the “two in the bush,” while dividends are the secure assets already in an investor’s possession.
Understanding the Bird in Hand
Myron Gordon and John Lintner developed this theory to challenge the Modigliani-Miller dividend irrelevance theory. According to the bird-in-hand theory, stocks with consistent and high dividend payouts are more attractive to investors, thereby commanding higher market prices. Investors who follow this theory trust that receiving returns through dividends is more certain than potential capital gains.
Bird in Hand vs. Capital Gains Investing
Investing for capital gains often involves speculation. While thorough research into the company, market, and macroeconomic conditions can improve chances, the ultimate performance of a stock is influenced by many uncontrollable factors.
Therefore, capital gains represent the “two in the bush” aspect of the adage. Though the potential for substantial gains exists, there is also the risk of minimal returns or even losses.
While broad stock market indices like the Dow Jones Industrial Average (DJIA) and the S&P 500 have averaged annual returns of around 10% in the long term, finding dividends that match such figures is challenging. Even industries known for high dividends, like utilities and telecommunications, rarely exceed 5%. Over the long term, consistent dividends, such as a 5% yield year after year, offer more reliable returns than uncertain 10% capital gains.
During years like 2001 and 2008, major stock indices suffered significant losses despite an overall upward trend. In such volatile years, the secure dividend income aligns with the bird-in-hand theory, providing reliability and peace of mind for investors.
Disadvantages of the Bird in Hand
Legendary investor Warren Buffett once noted that in investing, comfortable choices are seldom the most profitable. While dividend investing at 5% annually provides assured returns and safety, it typically underperforms pure capital gains strategies over the long haul. Additionally, there have been periods, such as the late 1970s, when dividend income failed to keep up with inflation, thereby diminishing purchasing power.
Example of Bird in Hand
Consider Coca-Cola (KO) as an example of a stock that fits a bird-in-hand theory-based strategy. The company started paying regular quarterly dividends in the 1920s and has increased these payments annually since 1964. Such consistency in dividend payments makes Coca-Cola an attractive option for investors seeking reliable returns.
Related Terms: dividend irrelevance theory, Modigliani-Miller theorem, capital gains, stock dividends.
References
- The Coca-Cola Company. “Dividends”.
