Swedroe: Irrelevance Of Dividends

August 17, 2016

Research has established that dividend policy should be irrelevant to stock returns, yet investors have long demonstrated an irrational preference for them. Mutual fund providers are well-aware of this fact.

Earlier this week, we reviewed a pair of studies showing that mutual fund managers exploit investors’ well-documented preference for cash dividends to attract assets by artificially “juicing” the dividend yield, and that they use dividend-chasing behavior strategically to benefit themselves at the expense of fund investors. Today we’ll tackle some possible explanations for investors’ 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 preference for the cash dividends anomaly in their 1984 paper, “Explaining Investor Preference for Cash Dividends.” They offered the following explanations.

First, 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, meaning they limit their spending only to the interest and dividends from their investment portfolio.

A “total return” approach that used self-created dividends would not address the conflict created by the individual who wishes to deny himself or herself 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 “prospect theory” (also referred to as loss aversion), which states that investors value gains and losses differently. As such, they will base decisions on perceived gains rather than on perceived losses.

So, if someone were given two equal choices, one expressed in terms of possible gains and the other in terms of possible losses, people would choose the former. Because taking dividends doesn’t involve the sale of stock, it’s preferred to a total-return approach that may require self-created dividends through sales. 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 essentially form over substance.

Whether you take the cash dividend or sell the equivalent dollar amount of the company’s stock, you’ll end up with the same amount invested in the stock. 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).


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