Bird In Hand

Absolute Advantage

What is Bird in Hand?

The Bird in Hand is a theory that says investors prefer the dividends of investing in stocks over potential capital gains because of the inherent uncertainty associated with capital gains. Based on the adage “one bird in hand is worth two in the bush”, the bird-in-hand theory states that investors prefer the certainty of dividend payments over the possibility of future capital gains substantially higher.

Key points to remember

  • The bird-in-hand theory says that investors prefer equity dividends over potential capital gains because of the uncertainty of capital gains.
  • The theory was developed as a counterpoint to Modigliani-Miller’s dividend irrelevance theory, which argues that investors don’t care where their returns come from.
  • Investment in capital gains represents the “two in the bush” side of the saying “one bird in the hand is worth two in the bush”.

Understanding the bird by 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 stock ownership come from dividends or capital gains. According to the bird-in-hand theory, investors who are looking for high dividends are wanted and, therefore, have a higher market price.

Investors who subscribe to the bird-in-hand theory believe that dividends are more certain than capital gains.

Bird in Hand vs. Capital Gains Investing

Investment in capital gains is based mainly on guesswork. An investor can gain an advantage over capital gains by doing in-depth research on companies, markets and the macro economy. However, at the end of the day, a stock’s performance is based on a multitude of factors that are beyond the investor’s control.

For this reason, investing in capital gains is the “two in the bush” side of the saying. Investors are looking for capital gains because it is possible that these capital gains are significant, but it is also possible that the capital gains are nonexistent or, worse, negative.

Large stock market indices such as the Dow Jones Industrial Average (DJIA) and Standard & Poor’s (S&P) 500 average annual returns of up to 10% over the long term. Finding such high dividends is difficult. Even stocks in the notoriously high dividend sectors, such as utilities and telecommunications, tend to exceed 5%. However, if a company has been paying a dividend yield of, say, 5% for many years, receiving that dividend in a given year is more likely than earning 10% in capital gains.

In years like 2001 and 2008, the major stock market indices suffered significant losses, despite an upward trend over the long term. In similar years, dividend income is more reliable and safer; therefore, these more stable years are associated with the theory of the bird in hand.

Disadvantages of the handmade bird

Legendary investor Warren Buffett once said that when it comes to investing, what is comfortable is rarely profitable. Investing in dividends at 5% per year offers almost guaranteed returns and security. However, in the long run, the pure dividend investor earns much less money than the pure capital gains investor. In addition, in some years, such as the late 1970s, dividend income, while secure and comfortable, was insufficient even to keep pace with inflation.

Example of bird in hand

As a dividend paying action, Coca-Cola (KO) would be an action that is part of an investment strategy based on the theory of the bird in hand. According to Coca-Cola, the company began paying regular quarterly dividends from the 1920s. In addition, the company has increased these payments each year for the past 56 years.

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