Appreciation vs cash flow investing philosophies

There are at least two major investment philosophies. The first is to invest for appreciation the other is to invest for cash flow.

Appreciation style investing is the “buy low, sell high” style that is favored on Wall Street and is likely the approach that you are taking when you look at your stock and bond portfolio. You are purchasing investments (maybe individual stocks, index funds, options, a house, or even gold or silver) with the expectation that they will be worth more when you are ready to sell them. And the intent is to sell the asset after a certain period of time to capture that increase. Your expected hold time can vary from seconds (in the case of a high frequency stock trader) to weeks (in the case of a house flipper) to decades (for stocks held in your retirement account).

The longer you hold the asset, the more likely that you will be able to sell it for more than you bought it for (in nominal dollars, not necessarily accounting for opportunity cost or inflation). If you hold the asset for over a year, you also get more favorable tax treatment as the profit would usually be treated as a long term capital gain (see your tax professional for details as to if / how this applies to your specific situation). The challenge is that your investment isn’t generating any returns while you are holding it. This is particularly difficult when you have to make payments to maintain the investment – for example, paying taxes on the dividends generated by an index fund held in a brokerage account or covering the holding costs (mortgage, taxes, insurance, etc.) of a house flip.

Most concerning to me, however, is that when you are ready to rely on your investments to live off of, you have to sell the investments to obtain the income required to support your lifestyle. This means that you will need to sell irrespective of what the market is doing at that time and will be consistently depleting your portfolio from the time you begin relying on it until you die (or it goes to 0). This is the foundation of the “4% rule” [1] which gives you an indication of how much you can safely withdraw from a normal, stock and bond based, retirement account to minimize the chances of completely depleting the account before you die.

For those that either plan to rely on their investments to live off of for much longer than 30 years (the timeline used by the 4% rule) or for who want to leave a legacy for others, portfolio depletion is not a great option. The risk of running out of money increases as the time you intend to live off your portfolio increases.

The alternative is to pursue a strategy of investing for cash flow instead of appreciation. In cash flow investing, you don’t intend to sell the investment so its long-term value isn’t as important. While it is always desirable for the value of the asset to increase, the real focus is on the cash flow that you get from the investment. Of course, if the price increases dramatically over expectations, there is always the opportunity to sell, but that isn’t the goal. This is typically the approach taken by long-term, buy-and-hold, real estate investors who look for the monthly income on the property to exceed expenses as well as for people buying dividend producing stocks and bonds.

Cash flow investors also benefit from holding the asset long-term as the difference between the investment’s income and expenses typically increase over time, generating more cash flow the longer the asset is held. For example, a company may increase its dividend payment [2] or the rent on a property may increase faster than the taxes and insurance costs. This is particularly noticeable in real estate, where the increase in rent roughly corresponds to the rate of inflation over the long term

The critical thing about cash flow investing is that once you have sufficient income from your investments to offset your expenses, you don’t have to worry about ever running out of money. You never have to sell your investments in order to generate the income you need to live. And you don’t need to work to ensure that your expenses are covered. So whether you plan for a long period of time living off of your investments or want to leave a legacy to your heirs, your overall estate doesn’t decrease as you live your life. You can spend your cash flow freely every year, while the underlying investments grow (or not) in value. And, depending on your personal situation and the type of investments you have made, much of that income could be tax free. In the end, your estate still has the cash flow coming in, and decisions can be made at that time about whether to sell the assets or maintain the cash flow.

This ability to never have to worry about running out of money is why I am focused on cash flow investments and look for long-term, buy and hold opportunities. I plan to live 40+ years off of my investments and would like to leave a legacy that can support my wife and causes I care about after I pass. So taking an appreciation / depletion approach would be risky (see a previous post with some concrete numbers [3]). I would need to put aside a lot more money under that approach than I would under a cash flow approach and I would still be at risk of running out of money in a protracted bear market.

If you have any questions or comment about this post, please email them to me at blog@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.

This article is my opinion only, it is not legal, tax, or financial advice. Always do your own research and due diligence. Always consult your lawyer for legal advice, CPA for tax advice, and financial advisor for financial advice.