Tuesday, December 2, 2008

The Capital Appreciation Model vs The Income Model

Update 12/21/08: Kim Snider just published an excellent report titled How to not just survive, but thrive, in turbulent financial markets,which describes the difference between the capital appreciation model and the income model, or what she terms the cash flow solution. I highly recommend that you download this report as she does a much better job of making the case than I do.

The goal of the capital appreciation model requires that the price of the assets you purchase rise in value over time. The goal of the income model does not. It only requires a steady, and potentially rising, stream of income from the assets you purchase.

Let's say there are two investors, Investor A, who uses the capital appreciation model, and Investor B, who uses the income model. And there are two stocks, ABC, which pays no dividends, and DEF, which pays a 5% annual dividend. The current stock price for both stocks is $50.

Investor A buys 100 shares of ABC at $50. If, at the end of a year, the price of ABC is $52.50, Investor A can sell the stock and realize a 5% annual gain. However, if the price of ABC is $50 or less, then Investor A has no realized gain for the year. Investor A needs the price of ABC to rise in order to realize a profit for the year.

Investor B buys 100 shares of DEF at $50. By the end of a year, Investor B receives $250 in dividends and realizes a 5% annual gain, regardless of the price of DEF. Investor B doesn't need the price of DEF to rise in order to realize a profit for the year, since the profit is provided by the income stream.

These are completely different strategies and you can't measure one by the goals of the other.

My covered call strategy is a modified dividend income strategy, similar to Investor B, but enhanced by selling covered calls. The market value of the stocks in my portfolio is less important than the income they produce. That income is reinvested, thereby compounding the returns, until such time as the income is needed. As long as the actual income from this portfolio meets or exceeds the projected income, its meeting its objectives, regardless of the current market value at any point in time.

Here's an good article titled "Seven Important Reasons for Dividend Investing", which provides the benefits of using an income strategy.

By combining dividend investing with a covered call strategy you can produce a fairly stable income stream.