The Twelve Rules of Investing, Rule #10: Understand the difference between income and cash flow

Posted on Posted in Financial Blog

“Income” is the interest and dividends generated by investments. “Cash flow” is the money that you need for living expenses. Many people mistakenly believe that you should get all your needed cash flow only from income and never touch the principal. How this myth began is a mystery, but modern finance says that there’s no difference between income and principal: If you need more cash flow than the income generated, sell some of an investment; if you need less, reinvest the income.

The point here is that you needn’t construct a portfolio to match income with your cash flow needs. Rather, structure your portfolio for the best total return after taxes and inflation (sound familiar?). In many cases, you’ll need to sell something from time to time to generate cash flow. But so what? If the total return on your portfolio is better because you’re not stuck in bonds and other low-return investments unnecessarily, you have more money to spend in the long run. And don’t forget taxes (see Rule #6): capital gains are more tax efficient than interest income.