Total real return investing

Common stocks

The reinvestment of increased earnings

Many years ago I met an old friend at a reception. He worked in the investment industry. I didn’t. I told him that in my investing I made no distinction between dividends and capital gains; that a dollar earned through a capital gain was as good as a dollar earned by dividends. He politely told me he thought I had it all wrong. He was particularly keen on real estate investment trusts (REITS) and was focused on yields.

I haven’t changed my view. I believe that being agnostic as to whether my returns come from capital gains or dividends has allowed me a more nuanced and beneficial view of investing in common stocks

Let me explain.

The object of the game

John Templeton, one of the investment greats of the 20th century, taught: “For all long-term investors, there is only one objective -“maximum total real return after taxes.”” (Proctor & Phillips, The Templeton Touch. 1983, 2012) p.153. ‘Total returns’ include dividends as well as price changes. A ‘real return’ is the return calculated after adjusting for inflation. We can leave aside for the moment the inflation adjustment to convert a total return to a total real return.

The nature of a common stock

As Jeremy Siegel points out, in the nineteenth century, common stocks were thought to only be suitable for speculators. The proper way to ‘invest’ was in bonds. In the early twentieth century the idea emerged that common stocks might outperform bonds in times of inflation. But, it was still thought that in times of deflation and disinflation, bonds were the only suitable investment.  (Siegel, Stocks for the Long Run – The Definitive Guide to Financial Market Returns and Long Term Investment Strategies. 1998) p. 45.

In the 1920s the true nature of investing in common stocks compared to bonds was explored by Edgar Lawrence Smith, a financial analyst and investment manager. He published his ideas in a book in 1925. His book was titled Common Stocks as Long Term Investments. Jeremy Siegel refers to Smith’s book as exploding popular conceptions about the performance of stocks compared to bonds.

On December 10, 2001 Carol Loomis’ report on the CNNMoney website contained an essay written by Warren Buffet based on a speech he had given the previous July. (Buffett W. , 2001) It may be found here.

The following are excerpts as written by Buffett:

“To report what Edgar Lawrence Smith discovered, I will quote a legendary thinker–John Maynard Keynes, who in 1925 reviewed the book, thereby putting it on the map. In his review, Keynes described ‘perhaps Mr. Smith’s most important point … and certainly his most novel point. Well-managed industrial companies do not, as a rule, distribute to the shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of their profits and put them back in the business. Thus there is an element of compound interest operating in favor of a sound industrial investment.’

It was that simple. It wasn’t even news. People certainly knew that companies were not paying out 100% of their earnings. But investors hadn’t thought through the implications of the point. Here, though, was this guy Smith saying, ‘Why do stocks typically outperform bonds? A major reason is that businesses retain earnings, with these going on to generate still more earnings–and dividends, too.’”

The reinvestment of increased earnings

Warren Buffett credits Philip Fisher as being, after Ben Graham, the greatest influence on his approach to investing. Fisher wrote: “If [investors] are saving any part of their income rather than spending it and if they have their funds invested in the right sort of common stocks, they are better off when the management of such companies reinvest increased earnings than they would be if these increased earnings were passed on to them as larger dividends which they would have to reinvest themselves.” (Fisher, P. A. Common Stocks and Uncommon Profits and Other Writings. 1958,1996) p.118. (Emphasis added)

He adds: “Therefor, [the investor] is usually running less risk in having this good management make the additional investment of these retained extra earnings than he would be running if he had to again risk serious error in finding some new and equally attractive investment for himself. The more outstanding the company considering whether to retain or pass on increased earnings, the more important this factor can become.” (Fisher, 1958,1996) p.119. (Emphasis added)

From a shareholder point of view

And what makes sense for shareholders? “…you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.” (Buffett, The Essays of Warren Buffett: Lessons for Corporate America. New York: Lawrence A. Cunningham. 1998) p125. (Emphasis added)

Total return investing for retirees

If the investor starts the year with a portfolio worth $100,000, to use a simple figure, and at the end of the year the portfolio with accumulated dividends is worth $110,000, the total return for the year is $10,000 or ten percent. It matters little whether the $10,000 return came from dividends or capital gains. If inflation is at 2% the investor can safely take $8,000 from the account and know that on a real basis, that is, adjusted for inflation, the portfolio remaining of $102,000 leaves the investor in the same position at the end of the year as at the beginning. If one cannot live from dividends alone and one is forced to sell some equities to produce the cash to live on, so be it. If the investor is using a discount broker the commission cost to sell a few shares from the portfolio on a regular basis is minimal.

Some advisors recommend holding sufficient cash to cover living expenses for, say, two years. This is foolish. It either sterilizes a substantial portion of the portfolio or causes investors to pick a time to sell that may or may not be at a good time (timing the market is bad).

There are two benefits to selling shares in smaller amounts on a regular basis. Most investors are aware of the concept of ‘dollar cost averaging’ in buying shares. Over a working lifetime investors do this naturally whether they plan it or not. Money is saved each month or year and regularly invested in the slowly building portfolio. This tends to smooth out the peaks and valleys in the market. When one retires, the regular sale of shares to generate money to live on is what one might call ‘dollar price averaging’. Regular but small sales tend to average out the prices obtained over an extended period of time. It tends to smooth out peaks and valleys in the timing of buying and selling. A second benefit to selling shares in smaller amounts on a regular basis is that one can use these sales to gently rebalance the portfolio using the selling principles discussed here.


The bottom line is that whether the return comes from dividends or capital gains or some combination of the two, makes absolutely no difference. You can live off your capital gains without depleting your capital if your total real return exceeds your expenditures.


For readers wishing to dig a little deeper into the idea of common stock investing take a look at the Motherlode Part 1: The Field of Play

That Part contains several chapters:

  1. Stocks Beat Every Other Asset Class
    2. Is it Worth it?
    3. Is it Possible?
    4. Risk and Uncertainty
    5. Efficient Market Hypothesis
    6. Inefficient Market Hypothesis
    7. Volatility
    8. The Economy and the Stock Market – Cycles and Trends


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