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What is the Bird in Hand Theory?
The bird-in-hand theory suggests that investors would prefer dividends from stock investments over capital gains. This theory believes that investors are likely to favour returns that are certain rather than uncertain. Because of the uncertainty involved around capital gains, the bird-in-hand theory assumes investors will always prioritize dividend investments.
The bird-in-hand theory comes from the old saying, “a bird in hand is worth two in the bush”. Therefore, this theory believes that investors prefer dividend investments because they are more secure than capital gains. Similarly, the theory suggests that even though capital gain investments may promise higher returns in the future, investors are likely to ignore them in favour of safer returns.
Where does the Bird in Hand Theory originate from?
Developed by Myron Gordon and John Lintner, the bird-in-hand theory opposes the dividend irrelevance theory. The dividend irrelevance theory suggests that dividends don’t have any effect on a company’s stock price. The irrelevance theory also proposes that investors are indifferent to whether they get returns from dividends or capital gains.
However, the bird-in-hand theory opposes the view by suggesting that dividends affect a company’s stock price. Similarly, it says that dividend payments also affect investors’ behaviours. The premise behind the bird-in-hand theory is that low dividend payouts lead to an increase in a company’s cost of capital. Therefore, a higher dividend payout rate increases a company’s stock price.
How does the Bird in Hand theory affect investors’ decision making?
When it comes to capital gains, investors have to face a significant amount of uncertainty. There is no metric that can reliably estimate how much capital gain a specific stock will experience. A stock’s ultimate capital gain performance depends on several factors. Some of these factors are unpredictable and outside a company’s control.
Therefore, capital gains investing can face investors with uncertain conditions and returns. For the substantial risks that investors face, they also get higher rewards. However, the risks may also result in significantly low or no returns at all. For some investors, the risks may not be acceptable for the returns they get.
The bird-in-hand theory works on that idea. It suggests that investors are more likely to choose safer investments rather than risky ones. Compared to capital gains, dividends are easier to predict and calculate. They also represent lower risks for investors. However, they also come with lower returns, which are significantly lower than capital gains sometimes.
What are the limitations of the Bird in Hand Theory?
The bird-in-hand theory goes against the idea that investors want to maximize their profits. By suggesting that investors will ignore high capital gains for dividends, this theory may offer higher security. However, it does not allow investors to maximize their returns. In the short-term, some investors may benefit from dividend investing. However, capital gains will almost always exceed any returns from dividends received in the long run.
Conclusion
The bird-in-hand theory states that investors prefer dividends returns rather than capital gains when investing in stocks. It is because it believes that investors are more likely to favour safer returns compared to uncertain earnings. The bird-in-hand theory opposes the dividend irrelevance theory, which suggests dividends do not impact a company’s stock price.
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