Why is it that investors have a hard time distinguishing between receiving dividends and selling shares?
It’s long been known that many investors have a preference for cash dividends. But from the perspective of classical financial theory, this behavior is an anomaly. Here’s why.
It’s perplexing behavior because before taking into consideration what are referred to as “frictions” such as transaction costs and taxes, dividends and capital gains should be perfect substitutes for each other.
Simply stated, a cash dividend results in a drop in the price of the firm’s stock by an amount equal to the dividend. That must be the case unless you believe that $1 isn’t worth $1.
Thus, investors should be indifferent between a cash dividend and a “homemade” dividend created by selling the same amount of the company’s stock. One is a perfect substitute, minus any frictions like transaction costs and taxes that come with the other. Thus, without considering frictions, dividends are neither good nor bad.
Warren Buffett made this point in September 2011. After announcing a share-buyback program for Berkshire, some people went after Buffett for not offering a cash dividend. In his shareholder letter, he explained why he believed the share buyback was in the best interests of shareholders. He also explained that any shareholder who preferred cash can effectively create dividends by selling shares.
For those who have a difficult time understanding this issue, I’ll provide some examples at the end of the piece. But for now, let’s focus on trying to explain the behavior.
Hersh Shefrin and Meir Statman, two of the leaders in the field of behavioral finance, attempted to explain the behavioral anomaly of a preference for cash dividends in their 1983 paper “Explaining Investor Preference for Cash Dividends.” They offered the following explanations:
The first explanation is that, in terms of their ability to control spending, investors may recognize they have problems with the inability to delay gratification. To address this problem, they adapt a “cash flow” approach to spending—they limit their spending to only the interest and dividends from their investment portfolio.
A “total return” approach that would use self-created dividends would not address the conflict created by the individual who wishes to deny himself a present indulgence, yet is unable to resist the temptation.
While the preference for dividends might not be optimal (for tax reasons), by addressing the behavioral issue, it could be said to be rational. In other words, the investor has a desire to defer spending, but knows he doesn’t have the will, so he creates a situation that limits his opportunities, and, thus reduces the temptations.
The second explanation is based on what is called “prospect theory.” Prospect theory (otherwise referred to as “loss aversion”) states that people value gains and losses differently. As such, they will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former.
Since taking dividends doesn’t involve the sale of stock, it’s preferred to a total return approach, which may require self-created dividends through sales. The reason is that sales might involve the realization of losses, which are too painful for people to accept, which they betray by exhibiting loss aversion.
Of course, what they fail to realize is that a cash dividend is the perfect substitute for the sale of an equal amount of stock whether the market is up or down, or whether the stock is sold at a gain or a loss. It makes absolutely no difference. It’s just a matter of how the problem is framed. It’s form over substance.