Swedroe: Irrelevance Of Dividends

August 17, 2016


It seems that investors all over the world are prone to the same behavioral mistakes, mistakes that lead them into a preference for dividends. While Shefrin and Statman showed that at least some investors may derive some benefit (such as help in controlling spending), the preference is irrational from a financial economist’s perspective. It can lead to reduced diversification benefits and higher tax costs. And it can lead at least some investors to fall prey to mutual funds seeking to exploit the typical retail investor’s lack of financial knowledge.

For the past 20 years, the workhorse model in finance has been the Fama-French four-factor model—the four factors being beta, size, value and momentum. The model explains the vast majority (about 95%) of the differences in returns of diversified portfolios.

Newer asset pricing models, which include the profitability, quality and investment factors, have added further explanatory power. Yet none of them include dividends as a factor. If dividends played an important role in determining returns, these models wouldn’t work as well as they do.

In other words, if dividends added explanatory power beyond that of the factors I just mentioned, we would have a model that included dividends as one of the factors. But we don’t. The reason is that stocks with the same “loading,” or exposure, to these common factors have the same expected return regardless of the dividend policy. This has important implications, because about 60% of U.S. stocks and about 40% of international stocks don’t pay dividends.

Any screen for dividend stocks 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, as they have a higher potential dispersion of returns without any compensation in the form of higher expected returns (assuming exposures to the factors are the same).

Additionally, you have seen how the preference for dividend stocks has driven dividend strategy valuations to levels well above the valuations of value strategies and the overall market. This should raise concerns about future returns.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.


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