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.
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.