What is a bird in hand?
The bird in hand is a theory that says investors prefer dividends from stock investing to potential capital gains because of the inherent uncertainty associated with capital gains. Based on the adage “a bird in the hand is worth two in the bush,” the bird-in-hand theory states that investors prefer the certainty of dividend payments to the possibility of substantially higher future capital gains.
Understanding Bird in Hand
Myron Gordon and John Lintner developed the bird-in-hand theory as a counterpoint to the Modigliani-Miller dividend irrelevance theory. The dividend irrelevance theory maintains that investors are indifferent to whether their returns from holding stock arise from dividends or capital gains. According to the bird-in-hand theory, investors seek out stocks with high dividend payouts, which leads to a higher market price.
Bird in Hand vs. Capital Gains Investing
Investing in capital gains is mainly predicated on conjecture. An investor may gain an advantage in capital gains by conducting extensive company, market, and macroeconomic research. However, ultimately, the performance of a stock hinges on a host of factors that are out of the investor’s control.
For this reason, capital gains investing represents the “two in the bush” side of the adage. Investors chase capital gains because there is a possibility that those gains may be significant, but it is equally possible that capital gains may be nonexistent or, worse, damaging.
Broad stock market indices such as the Dow Jones Industrial Average (DJIA) and the Standard & Poor’s (S&P) 500 have averaged annual returns of up to 10% over the long term. They are finding dividends that high is difficult. Even stocks in notoriously high-dividend industries, such as utilities and telecommunications, tend to top out at 5%. However, if a company has been paying a dividend yield of, for example, 5% for many years, receiving that return in a given year is more likely than earning 10% in capital gains.
During 2001 and 2008, the broad stock market indices posted significant losses despite trending upward over the long term. In similar years, dividend income is more reliable and secure; hence, these more stable years are associated with the bird-in-hand theory.
Disadvantages of the Bird in Hand
Legendary investor Warren Buffett once opined that, as far as investing is concerned, what is comfortable is rarely profitable. Dividend investing at 5% per year provides near-guaranteed returns and security. However, over the long term, the pure dividend investor earns far less than the pure capital gains investor. Moreover, during some years, such as the late 1970s, dividend income, while secure and comfortable, has been insufficient to keep pace with inflation.
Example of Bird in Hand
As a dividend-paying stock, Coca-Cola (KO) would be a stock that fits in with a bird-in-hand theory-based investing strategy. According to Coca-Cola, the company began paying regular quarterly dividends in the 1920s. Further, the company has increased these payments every year since 1964.
Conclusion
- The bird-in-hand theory says investors prefer stock dividends to potential capital gains due to the uncertainty of capital gains.
- The theory was developed as a counterpoint to the Modigliani-Miller dividend irrelevance theory, which maintains that investors don’t care where their returns come from.
- Capital gains investing represents the “two in the bush” side of the adage “a bird in the hand is worth two in the bush.”
