Swedroe: Investors’ Odd Affection For Dividends

February 24, 2017

It has long been known that many investors have a preference for cash dividends. From the perspective of classical financial theory, this behavior is an anomaly. My hope is that this article will provide you a better understanding of the relationship between dividends and price changes, helping you to characterize the gains from each appropriately and avoid some of the negative consequences that can result from this anomaly.

Dividend Policy Irrelevant To Returns

In their 1961 paper, “Dividend Policy, Growth, and the Valuation of Shares,” Merton Miller and Franco Modigliani famously established that dividend policy should be irrelevant to stock returns.

As they explained it, at least before frictions like trading costs and taxes, investors should be indifferent to $1 in the form of a dividend (causing the stock price to drop by $1) and $1 received by selling shares. This must be true, unless you believe that $1 isn’t worth $1. This theorem has not been challenged since.

Moreover, the historical evidence supports this theory—stocks with the same exposure to common factors (such as size, value, momentum and profitability/quality) have the same returns whether they pay a dividend or not. Yet many investors ignore this information and express a preference for dividend-paying stocks.

One frequently expressed explanation for the preference is that dividends offer a safe hedge against the large fluctuations in price that stocks experience. But this ignores that the dividend is offset by the fall in the stock price. It’s what can be called the “fallacy of the free dividend”—the only free lunch in investing is diversification, not dividends.

What is particularly puzzling about the preference for dividends is that taxable investors should favor the self-dividend (by selling shares) if cash flow is required. Unlike with dividends, where taxes are paid on the distribution amount, when shares are sold, taxes are due only on the portion of the sale representing a gain. And specific lots can be designated to minimize taxes.

Are Investors Disconnected?
Samuel Hartzmark and David Solomon contribute to the literature on the dividend anomaly with their November 2016 study, “The Dividend Disconnect.” They examined whether investor behavior was disconnected from financial theory and reality by examining the trading and pricing of securities.

In other words, do investors behave as if dividends are a free lunch? They found that by creating a separate “mental account” for dividends, the dividend disconnect did in fact have considerable impact on investor trading related to gains and losses, the prices of dividend stocks and dividend reinvestment.

First, the authors found that investor-trading behavior is driven by past price changes rather than past returns. In other words, they treat two stocks whose prices rose from $5 to $6 the same, even though one first went to $7 and then paid a $1 dividend, which lowered the price to $6.

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