The words "principal" and "net income" on an investment are usually assumed to have a clear and simple meaning. A man puts $1,000 of his principal into a savings deposit; during the year the bank credits him with $30 interest, and this is his net income. If he buys 100 shares of corporate stock, those shares are his principal, and when the company pays him a dividend, that is his net income. Traditionally, when a family de­rives all or most of their income from investments and pensions, they are expected to spend their net income but to leave their principal or capital intact. Unfortunately, when confronted with some of the queer facts of investing, these simple distinctions between principal and income get kind of blurred.

Income-Tea Rules

The Federal income-tax rules naturally affect an investor's notions of what constitutes income. Mostly, those rules agree with the above definitions, the main question being on the proceeds from a sale of principal. When a depositor closes a savings account, the bank pays him exactly the same number of dollars that he deposited. If he left his interest on deposit, the bank has added that to his principal, but he is supposed to have reported that interest as taxable income. There is no question of a gain or loss in value of principal.

But when a shareholder sells stock, he is almost certain to have either a gain or loss in the dollar value of his principal. Now how do we treat this change in value? Does it affect principal or income? The Federal income-tax rule is that when the seller has owned the stock for not more than six months, a gain in value is taxable income, and a loss is subtracted from income. (We omit some tax technicalities.) Since only a speculator is apt to sell stock as soon as six months after he buys it, we need not discuss this part of the tax rule.

When a man has owned stock for more than six months, the tax rule is that he has a "long term" gain or loss, and half of it goes into taxable income. Suppose a man paid $1,000 for stock, and ten years later he sold the same shares for $2,000, a gain of $1,000. According to the tax rule, in the year of sale he has $500 extra income, and the other $500 presumably he should add to his principal. There is plenty of argument about the fairness and wisdom of this rule.

A shareholder in an investment company encounters this same question, even though he never disposes of any shares of stock. Nearly all investment companies, from time to time, sell some of the stock they hold; and on a company's total sales during a year, if it receives more than it paid for the same stock it must pass this capital gain on to its own stock­holders as a capital-gain dividend or distribution. For a stockholder, the Federal tax rule says this distribution is a long-term gain, so that half of it is taxable income. Most of the investment companies pay a capital-gain dividend in the form of additional shares of stock, except when a stockholder asks for cash. But whether paid in new shares or cash, the Federal tax rule says half of the dividend is net income.

Regardless of the tax rules, it is more conservative for a stockholder not to spend capital gains, whether received as proceeds of a sale or as dividends. Here are some reasons:

1. Obviously these gains show up only when prices are higher than formerly. Later on, if a stockholder is obliged to sell stock when its price is low, he will wish he had reinvest­ ed his gains in the palmy days.



2. His future income dividends will be larger if he re­invests capital gains.



3. Future inflation may cut the buying power of some of his investments, or his pension income, and to offset this he may need to reinvest capital gains on stock. We will return to this point shortly.



4. Capital gains are so irregular in amount that if they are considered as spend able, they had better be averaged over enough years to make their spending a fairly uniform amount per year. On an investment company's capital-gain dividends, probably averaging for ten years is desirable. But reinvesting them all is simpler!

Growth Stocks

For a different aspect of the distinction between net income and principal, let us look at the poor dividends paid on "growth stocks." On a corporation's books, after all expenses have been subtracted from gross income, the remainder, the net income or net earnings or net profit, belongs to the stockholders of the corporation; but a good deal of it is not passed on to the stockholders as dividends.

Federal income-tax rules make it practically compulsory for an investment company to pay nearly all of its net income to stockholders. But other corporations generally suf­fer no tax penalty for withholding part of their earnings, and the portion withheld ranges anywhere from zero to 100 per cent.

The main reason why a corporation withholds income is that it needs additional capital for expansion or improvement; and rather than obtaining that capital by issuing new stock or borrowing, the company management prefers to hang on to a considerable portion of its own net income. The more rapidly a company is expanding its sales, or improving its equipment, the larger the portion of net income it is apt to withhold. Thus a growing company may have fine profits and still may pay small cash dividends. In Wall Street, the stock of such a company is called "growth stock."

Assuming that a company will continue to be successful, the reinvesting of its earnings will result in increasing its income, and in anticipation of this, the market price of its stock goes up. Thus on a growth stock, the market value is high compared to the dividend.

A reader may think: "Owning a growth stock is a good idea for a man who does not need current income from his investments. But I need net income, so why should I own growth stocks?" The answer is that the total results, com­bining both dividends and growth in value, are apt to be better on growth stock. Concentrating on just a few of these stocks is risky, for they may turn out to be duds. But an in­vestor can readily diversify in them by buying shares in a mutual fund, which puts most or all of its assets into growth stocks.

Where a mutual fund has a fine total-performance record but an investor feels its dividend rate is too low a percentage of its value per share, he might think this way: "This fund owns stock in growth companies, whose net income is much larger than the dividends they pay to the mutual fund, and which the fund passes on to me. So if I sell a few percent of my shares in this fund each year and treat the proceeds as income, I am merely reversing what the growth companies do when they convert their income to capital. My remaining capital value will probably be larger than if I owned stock paying good dividends and spent only the dividends."

Preserving Buying Power

When an investor says, "I need income now," the proba­bility is mat he will continue to have just as great a desire for income as long as he lives; and usually he must also provide for someone else's lifetime. So he needs assurance that he can continue into the indefinite future with whatever rate of spending he adopts now, and further that his buying power will not suffer.

For this situation, let us try a new definition: "spend-able income" is the amount an investor can spend without suffer­ing a loss of buying power on his future income or principal. Admittedly that is pretty vague, but by accepting this idea a man can improve his chance of keeping a balance between present and future spending.

Suppose the annual net income of a retired man and his wife is like this: Their U. S. Social Security benefits are $2,000. On an employer-sponsored pension their benefits are $1,000, and on a savings deposit they draw $500 interest; combining these two, they have a fixed dollar income of $3,500. From common stock they have dividends of $1,500 this year. Total income is $5,000. To simplify the illustration, let us assume that they plan to preserve their capital for their heirs; this eliminates the possibility of increasing their income in old age by converting capital into annuities, thus consuming their principal during their lifetimes. Also let us assume that the cost of living is going to rise 2 per cent annually, as suggested in the chapter headed "What Is Se­curity?"

Under these conditions, if the couple spend all of then* income this year, will next year's income give them an equal buying power? To keep up with the cost of living, next year's income should be $5,000 plus 2 per cent, or $5,100. Social Security benefits, judging by the record to date, will be adjusted to cost of living, but in a delayed and irregular man­ner. For simplicity here, we make the optimistic assumption that next year the Social Security benefits will go up to $2,040, in line with the cost of living. The fixed dollar income will remain at $1,500. To obtain the desired total income, the dividends on stock must be $1,560, a rise of 4 per cent in one year. It is not sufficient for the dividends merely to in­crease 2 per cent; to offset the buying-power lost on fixed dol­lar income, dividends should go up twice as fast as the cost of living, and lots of common stocks cannot be expected to do that well.

Suppose the past record of the couple's stock indicates that dividends will about keep up with the cost of living, rising next year to $1,530. Total income will be $5,070, short $30 of what is needed. This discrepancy for next year is small, but each succeeding year it will be compounded, until in a few years it will become a serious reduction in buying power. To conform to our definition of spend-able income, the couple should increase their capital by reinvesting something like one tenth of their total income. This means that their spend-able income is only about 90 per cent of their nominal dollar in­come.

Earlier in this chapter we suggested that on a growth stock, with market value having a long-term tendency to rise rapidly, some of this value increase can be treated as spend-a­ble income. But the retired couple we are discussing now could use growth stock in a somewhat different way. If the cost of living continues to rise, they know the buying power of their fixed dollar income will shrink. Now if their common stock is in a diversified growth-stock fund with a good per­formance record, the couple can expect either that dividends on this stock will go up enough to keep their total income in line with the cost of living, or else the stock's market value will rise fast enough to permit them to sell a few shares without hurting the buying power of their total capital.

A cautious stockholder must remember that while, with a diversified group of common stocks, the long-term trend of dividends and market value is pretty likely to be strongly upward, still the future is unpredictable, especially for any one year. So to play safe he estimates that in the next few years dividends and values will be poor. This requires him to hold down the current year's expenses. When next year ar­rives, probably its dividends and values will be better than his low estimate. Whether an investor thinks this is good or bad, it is a necessary accompaniment to sensible owning of common stock or other equities for higher net income.