Words matter.

They matter even more in quantitative disciplines.

Words matter. In finance, supposedly the realm of quantitative certainty, words matter even more. Consider the words in the introduction to M&M’s famous 1961 dividend irrelevance article. Widely cited, rarely read, and almost always misinterpreted, the article makes an important but narrow blackboard argument about companies that have capital expenditures greater than free cashflow. Period. In that realm, it was correct then and still applies now to a handful of companies—most REITS, some utilities, a few others —in a variety of sectors that are strapped for cash. Otherwise, for most of the market, M&M 1961 need not apply in 2024. QED.

But let’s step back and consider a more fundamental issue, one at the very heart of what it means to be a Dividend Investor in a Stock Market. And it is rooted in words, the means that we use to frame investment questions or problems. That framing has an enormous impact on the answers or the solutions.

In our industry, for instance, the calculation of total return from a stock appears to be quite straightforward: change in share price (positive or negative) plus any dividend received in the measurement period. A maxim in modern finance—reflected in the definitions section of M&M 1961—holds that investors are indifferent between the two types of return—dividend vs. capital gain.

It seems simple, but it is not. That definition and assumption does not draw a distinction between a simple capital gain—green on the screen—and an actual harvested or realized gain—cash in the kitty. Other foundational statements either don’t address the difference or lean towards accepting with equanimity unrealized gains as the equivalent of realized dividends. Markowitz’s very short 1952 paper does not define return, but in his expanded version in 1959, he threads his way through the definitional maze. In the investment example that he uses to structure the book, total return appears to be the realized version, conveniently sold at the end of a measurement period.

Immediately thereafter, he puts “return” in quotation marks and argues that his analysis applies to both realized and unrealized gains, and that both are “identical” to dividend payments.

Later in 1959, Markowitz revises his math, but not his definitions, for instances when taxes are applied to capital gains, assuming therefore that they have been harvested.

So the founding fathers are squishy on this point, either not acknowledging the two different capital gains scenarios or not noting any difference between them. The broader regulatory environment and operating environment in our industry also make no distinction, but defaults in the direction of the broader green-on-the-screen definition of a capital gain.

Nearly three quarters of a century after the founding of modern academic finance, I beg to differ. For a Dividend Investor in a Stock Market, a dividend is not the same as a capital gain, and an unrealized capital gain is most certainly not the same as a dividend. They are not “exactly equivalent to a dollar of dividends, no better and no worse.” Does it matter? Why bring it up now? These were academics, not businesspeople, writing mostly for other academics. Their other shortcuts and assumptions (no “frictions” of any kind) are well known and understood to be necessary to create systems in equilibrium.

This topic is taken up at length in The Ownership Dividend, but has come to a head recently with the phenomenon of a particular chip stock. Its chart is below. Is this really total return? Are you sure? Is this green-on-the-screen return the type you would use to measure your wealth? In this particular instance, this wealth generates essentially no income. That’s a funny kind of extreme wealth. Still, for some, the answer might be yes. But unless you have cashed out your chips somewhere near the top, this extreme positive “total” return seems quite contingent and theoretical.

I have in the past written about the difference between dividends and harvested capital gains. One is a business outcome; the other is a market outcome. I’ll die on that hill. In fact, I already have. Very few people have accepted that argument.

Here I am extending that argument to another hill: the difference between unrealized capital gains and realized ones. I am well aware that the difference has no legal or regulatory standing. Your brokerage statement considers both to be the same.

But there is a common-sense distinction. An unharvested capital gain really can’t do anything. It just is. It is only activated when harvested. Only then can it be consumed or invested elsewhere. Until then, it is a theoretical gain. It probably will be there tomorrow morning, but maybe not. You just don’t know. Treating an unrealized gain with the same mathematical certainty as a harvested one or a dividend payment seems a stretch in the real world, even if it is perfectly reasonable in a finance classroom.

Using another name or category for unrealized capital gains is unlikely to happen anytime soon. It’s just too complicated. But for individual investors, it is worth pondering and being aware of the difference in your portfolio. What is the percentage of your “return” coming from income, the percentage coming from realized capital gains, and the percentage coming from unrealized capital gains? Is there an ideal balance?

Like risk and reward, there is a spectrum of return that will vary by investor. Not surprisingly, I value dividends first, realized gains second, and unrealized gains only last. I don’t count on them. Others will reverse that order and be happy to have all their nominal wealth tied up in unrealized gains.

Academic finance and government regulators would do well to acknowledge the real-world differences between these forms of return. We’ve come a long way from when “return” was the spices brought back to London on British East India ships in the 17th century. It is time to realize our current definitions may not be fit for purpose.