Swedroe: Irrelevance Of Dividends

August 17, 2016

Consolation Prizes
Shefrin and Statman write: “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.”

They point out that if the sale involves a gain, the investor frames it as “super added benefit.” However, if the investor incurs a loss, he frames it as a silver lining with which he can “console himself.” Because losses loom much larger in investors’ minds, and because 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:

1) You take $600 received as dividends and use it to buy a television set.

2) 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 one or in case two? Since cash dividends and self-dividends are substitutes for each other, you should feel no more regret in the second case than in the first case. 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. When 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 an investor’s life cycle. As mentioned previously, a theory incorporating self-control is used to justify spending only from a portfolio’s cash flow, never touching the principal.

Younger investors, who generate income from their labor capital, might prefer a portfolio with low dividends, as a high-dividend strategy might encourage dis-savings (spending from capital). On the other hand, retired investors with no labor income would prefer a high-dividend strategy for the same reasons, to discourage dis-savings. A study of brokerage accounts found that a strong and positive relationship between age and the preference for dividends did in fact exist.

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 self-control issues (such as a weakness for impulse buying) may find that, while there are some costs involved, the benefits provided by avoiding behavioral problems may make a cash dividend strategy a rational one.

Before summarizing, we have one more important point to cover. It involves how popularity drives down returns.

 

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