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.
Second, when they examined the disposition effect (the tendency to sell winners more often than losers) they found that there was considerably less selling response to the dividend component (investors focused on the price instead of on the total return).
Third, they found that investors are less likely to sell stocks that pay dividends, holding them for longer periods. Dividends also made investors less sensitive to past price changes when selling.
A fourth important finding was that investors’ demand for dividends is higher when interest rates are low and recent equity returns have been poor. They also found that investors’ demand for dividends is higher when dividends are more stable. Once again, this demonstrates that investors have separate mental accounts for the two components of return, treating dividends more like interest payments while ignoring the source of the dividend and its impact on the stock price.
Additionally, the authors found that the demand for dividends is lower when recent stock returns have been higher—the dividend component appears less attractive than capital gains despite both contributing to the total return.
Fifth, the authors found that dividends tend not to be reinvested in the same company. This was true of retail investors (who may find it difficult to reinvest dividends unless the company has a DRIP program), and more sophisticated institutional investors (who don’t have the same consumption motivation that retail investors have).
Specifically, they found that, for individual investors, dividend reinvestment is only about 2% as common as no change in the number of shares held. For institutional investors, it was only about 10% as common.
In other words, investors seem to be expressing that they have a desire to reduce their holdings by the exact amount of the dividend paid! It seems far more likely that there is separate mental accounting and that investors ignore the equivalency theory behind the actions.
Separate Mental Accounts
These results provide direct evidence that investors do, in fact, treat dividends in a more naive way than predicted by financial theory, creating separate mental accounts for them. The findings are also consistent with prior research, which has shown that investors prefer to consume out of their dividends.
Hartzmark and Solomon concluded that “the free dividends fallacy not only explains psychologically why dividends may be desirable, but also why the shifting attractiveness of dividends and capital gains can generate time-varying demand for dividends which firms respond to.” For example, as I’ve written about before, it has been well-documented that some mutual funds “juice” their dividends by buying stocks just before the ex-dividend date.
In addition, research has shown that firms tend to increase their dividends when dividends are more overvalued. The authors added that the mental accounting of dividends as an income stream can also explain the documented preference among older investors for dividends.
Another important finding involved investor preference for dividends during periods of high demand (low interest rates and bear markets), causing them to be relatively overpriced (which shows up in higher price-to-book value). This negatively impacted returns by 2% to 4%, resulting in a significant loss of the equity risk premium. Unfortunately, this isn’t the only negative impact of the preference for dividends.
As mentioned previously, taxable investors should have a preference for capital gains over dividends. And there are negative implications in terms of diversification.
Because about 60% of U.S. stocks and about 40% of international stocks don’t pay dividends, any screen that includes dividends results in portfolios that are far less diversified than they could be if dividends were not included in the portfolio design. Less-diversified portfolios are less efficient because they have a higher potential dispersion of returns without any compensation in the form of higher expected returns (assuming the exposure to investment factors are the same).
These negative implications are why the preference for dividends is considered an anomaly. The field of behavioral finance has attempted to provide us with explanations for the anomalous behavior.
Attempting To Explain The Preference For Dividends
Hersh Shefrin and Meir Statman, two 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, he or she would choose the former. Because 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 (they exhibit loss aversion).
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, at the end of the day, 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, point 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.”
Yet Another Explanation
They also 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.” Given that losses loom much larger in investor’s minds, and they wish to avoid them, investors prefer to take the cash dividend, avoiding the realization of a loss.
The authors 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 the first or second case? Because cash dividends and self-dividends are substitutes for each other, you should feel no more regret in the second case than in the first. However, evidence from studies on investor 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 over 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 dissavings (spending from capital). On the other hand, retired investors, with no labor income, might prefer a high-dividend strategy for the same reasons, to discourage dissavings. A study of brokerage accounts found there was a strong and positive relationship between age and the preference for dividends.
While the preference for cash dividends is an anomaly that cannot be explained by classical economic theory, which is based on investors making “rational” decisions, 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.
The bottom line is that both theory and historical evidence demonstrate that dividends are just another source of profit, along with capital gains, and that dividends mechanically reduce the price of stock. Yet many investors treat the two sources of profit very differently, with negative consequences both in terms of lower returns and greater risk.
However, Shefrin and Statman provide us with explanations demonstrating that, at least for some investors who are otherwise unable to control their spending, the negative consequences may be outweighed by the benefits in terms of controlling behavior that would have had even greater negative consequences.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.