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Demystifying the Dividend Fascination

Oct. 4, 2023, 8:11 a.m. |Investment Philosophy |Beginner

Hey folks, let's deep-dive into the world of dividends – that rewarding system where companies share a piece of the profit pie with their stockholders. It's no secret that many investors have a big crush on dividends, but classical financial theory kind of suggests that this crush might be a little irrational. Why? Let's get into it.

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Way back in 1961, Miller and Modigliani said in their big-deal paper that a company's dividend policy shouldn't really matter when it comes to stock returns. Essentially, they were saying that a buck earned through dividends should equal a buck made by selling shares. Simple, right?

Despite this, dividends have had folks, especially Canadians, wrapped around their finger for ages, almost acting like a safety net against market downswings. But spoiler alert: this is more of a misconception because dividends usually lead to a dip in the stock's price, balancing out the gains.

Fast forward to 2018, behavioral finance gurus, Samuel M. Hartzmark and David H. Solomon published their fresh insights in a working paper titled "The Dividend Disconnect." They pointed out some severe downsides to the dividend love affair.

First, the so-called "free dividend fallacy" comes with a price tag. Picture this: when you receive dividends, you're likely to face tax implications. This can potentially be worse than selling shares, where you'd only be taxed for the capital gains if you sold them at a higher price. So, while avoiding the trading costs of selling shares might seem like a win, it might just backfire on the tax front.

Another red flag? If an investor gets a dividend and chooses not to reinvest it, they miss out on potential future returns – a classic case of losing sight of the bigger picture. Unfortunately, the majority of investors do not reinvest the dividends in the same company and lose potential future returns.

The paper further highlighted a more disturbing trend: investors seem to rally for dividends simultaneously. This uniform demand shakes up the book-to-market ratio of dividend-paying stocks, indicating that during high-demand phases, these stocks could be overvalued and likely offer lower returns in the future. So, when everyone is running after dividends, it might be a signal that the returns are about to take a dip.

Why Do People Prefer Dividends Anyway?

So, what's behind this strong preference for dividends? Hersh Shefrin and Meir Statman, prominent figures in the behavioural finance sphere, ventured to explain this in their 1983 paper. Their observations were fascinating:

  • Self-Control Issues: Some investors consciously choose dividends to curb their spending habits, effectively restricting themselves from spending only what they earn through dividends and interest.
  • Avoiding Painful Losses: The very thought of selling stocks, possibly at a loss, is a painful prospect for many. Dividends don't come with this baggage; they're seen as gains, not potential losses.
  • Regret Avoidance: Interestingly, people feel less regret about spending their dividends than selling their stocks for the same amount, especially if the stock price shoots up later.
  • Life-Stage Preferences: Young and earning individuals might not prefer dividends as they encourage spending from their capital, while retired individuals lean the other way.

Despite classical economic theory encouraging a rational approach to financial decisions, the allure of dividends appears reasonable for those grappling with self-control issues.

Now, breaking down this info, we see that the old-school charm of dividends kind of guides investors into a trap of lower returns and possibly heftier taxes, a real bummer if you ask me.

But wait, there's a twist! For those with a penchant for overspending, having a 'dividend strategy' might just be what the doctor ordered, helping them rein in their spending habits and navigate their financial journey with more wisdom.

So, What's the Big Takeaway?

To wrap this up – while dividends have this warm, cozy appeal to investors, the ground reality might be a bit different. It's like being drawn to the bright lights of a big city only to realize the cost of living is sky-high.

So, while dividends feel like a comforting, reliable old friend, they come with their own set of complications, sometimes leading to riskier choices and lower returns. But hey, for the spendthrifts among us, holding onto that old friend might just be the saving grace they need.

We prefer a total return portfolio including dividends, future growth, and tax-efficient capital gains. Every strategy has its pros and cons, but the dividend tail should not wag the portfolio dog. The only free lunch in investing is still diversification; even though pundits of dividends try to make you believe it is a free lunch, it is not.

Let's stay savvy, investors!

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