Swedroe: Dividends And Behavioral Econ
Whether you take the cash dividend or sell the equivalent dollar amount of the company’s stock, you will have the same amount invested in the stock. It’s just that with the dividend, you own more shares, but at a lower price (by the amount of the dividend), while with the self-dividend, you own fewer shares but at a higher price (because no dividend was paid).
As Shefrin and Statman pointed out in their paper: “By purchasing shares that pay good dividends, most investors persuade themselves of their prudence, based on the expected income. They feel the gain potential is a super added benefit. Should the stock fall in value from their purchase level, they console themselves that the dividend provides a return on their cost.”
The authors point out that if the sale involves a gain, the investor frames it as super added benefit. However, if a loss is incurred, he frames it as “a silver lining with which he can console himself.” Because losses loom much larger in investors’ minds and they wish to avoid them, they prefer to take the cash dividend, avoiding the realization of a loss.
Shefrin and Statman offer yet a third explanation: regret avoidance. They ask you to consider two cases:
- You take $600 received as dividends and use it to buy a television set.
- You sell $600 worth of stock and use it to buy a television set.
After the purchase, the price of the stock increases significantly. Would you feel more regret in case 1 or in case 2? Since cash dividends and self-dividends are substitutes for each other, you should feel no more regret in case 2 than in case 1. However, evidence from studies on behavior demonstrates that for many people, the sale of stock causes more regret. Thus, investors who exhibit aversion to regret have a preference for cash dividends.
Shefrin and Statman go on to explain that people suffer more regret when behaviors are taken than when behaviors are avoided. In the case of selling stock to create the homemade dividend, a decision must be made to raise the cash. When spending comes from the dividend, no action is taken, thus less regret is felt. Again, this helps explain the preference for cash dividends.
The authors also explain how a preference for dividends might change during the investor’s life cycle. As mentioned earlier, the theory of self-control is used to justify the idea of spending only from the cash flow of a portfolio, never touching the principal.
Younger investors, generating income from their labor capital, might prefer a portfolio with low dividends, as a high-dividend strategy might encourage “dis-savings.”
On the other hand, retired investors, with no labor income, would prefer a high-dividend strategy for the same reasons, to discourage dis-savings (spending from capital). A study of brokerage accounts found there was in fact a strong and positive relationship between age and the preference for dividends.
The bottom line is that the preference for cash dividends is an anomaly that cannot be explained by classical economic theory, which is based on investors making “rational” decisions.
But investors who face issues of self-control—such as being subject to impulse buying—may find that while there are some costs involved, the benefits provided by avoiding the behavioral problems may make a cash dividend strategy a rational one.
My next article will continue this discussion and provide detailed examples to better illustrate the world of dividends.
Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.
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