CFB. If you spend your capital gains how do you grow your portfolio?
If you don't mind me answering this, I'll take a shot.
If your mutual fund holds 1000 stocks, and sells 200 of them (partial or full sale) during a year, you only have capital gains (or losses) on those 200 sales. I think a mutual fund must distribute at least 90% of those capital gains, as well as dividends.
The other 800 stocks can increase (or decrease) in value, but if they haven't sold them there is no cap gain and no cap gains distribution. So the mutual fund can increase in value (growing your portfolio) through the stocks it continues to hold AND also provide a flow of income through distributions on the stocks it sells and dividends the stocks pay.
It's all variable based on how much trading there is in the fund, and how profitable the trading was. Dividend distribution tends to be more steady but there's no guarantee the fund manager will stay with some of those dividend producing stocks. And a lot depends on the type of fund. Actively managed funds tend to have more turnover and generate larger distributions than index funds.
That's why I don't think I'll plan on those alone as my cash flow and won't necessarily adjust my spending based on having larger or smaller distributions.
But it is a way of getting a cash flow that seems to be more or less what I think I will need. Some years I may need to liquidate more assets, others I may need to reinvest some of the distributions based on how much I get, and I may need to rebalance assets, but I think it will take some of the decision making on which assets to sell out of my hands. Or rather, when I make those decisions, most of the time it will be because of rebalancing or doing it on the merits of the investments, rather than having to make a decision to sell because I need the cash, either immediately or to fund a CD ladder for the future.
Put another way, reinvesting distributions is literally buying more shares of the mutual fund. It's a good forced savings while you are accumulating a nest egg. But when you are needing income from your investments, it doesn't make sense to me to automatically buy more of the mutual fund and have to sell something else. I'll take the money from the distibutions and then decide whether I want to use the money as income, invest in something else, or invest it back into the same fund.
As far as rebalancing goes,
generally in a good year a stock fund will both have more distributions and also grow in value, so it makes sense take the distributions away from it. And in a bad year it
generally has a smaller distribution and may go down in value, so it makes sense to get income from another source that had been doing better. Lots of exceptions there, of course, but I think the strategy is consistent with trying to keep a portfolio balanced without have to exchange assets too much.
There's probably a flaw in there that distributions and dividends from bond and money funds may be higher and throw off the balance. I still need to study that and see if I need to adjust my strategy.
