Tuesday, February 1, 2011

Emotional Benefits of Dividend Investing

Dividend investing is very popular. Many investors like to have their long-term savings in a collection of dividend-paying stocks. There can be good reasons for preferring dividend-paying stocks over other stocks, but I suspect that the main benefits are emotional.

For investors in the lowest tax brackets, dividends are taxed less than capital gains. This is one good reason to prefer dividends over capital gains. However, most of the dividend investors I know are in a high enough tax bracket that they would be better off with capital gains.

Some investors believe that dividend-paying stocks pay a larger total return (dividend plus capital gains) than non-dividend-paying stocks. All evidence I’ve seen says that this isn’t true.

Some investors believe that long-time consistent dividend-paying companies are less risky than other stocks. I have no opinion one way or the other on whether this is true, but I don’t think this is the dominant reason why some investors prefer dividend-paying stocks.

From my observations, the real reasons for dividend investing are emotional. It feels good to collect dividends. You still have the same number of shares and now you’ve got some extra cash. The fact that each dividend reduces the capital value of the shares isn’t front and center in the investor’s mind.

Dividend reinvestment feels good as well. The number of shares you own grows over time without having to invest more money. Of course, if the company had retained the earnings instead of paying a dividend, the result would be essentially the same. In the non-dividend case, your number of shares doesn’t rise, but each one is worth more.

To illustrate how this works, imagine that you’ve got 2100 shares of XYZ Corporation trading at $20 each. Over the course of a year, the value of the business rises 10%. If no dividend is paid, you’d have 2100 shares worth $22 each. But, if XYZ pays a $1 dividend, the shares would rise to only $21, and you’d be able to buy another 100 shares with your $2100 dividend. So you’d have 2200 shares worth $21 each. With or without the dividend, the total value of your shares would be $46,200.

When it comes time to live off your savings, it feels better to collect dividends and spend them than having to sell off some of your shares to generate income. Once again, there is no real difference when you go through the math, but it feels bad to see your number of shares dwindling even if the total value of the shares is identical whether a dividend is paid or not.

Hard core dividend investors may have good reasons for their choice that I haven’t mentioned here, but my own observations are that the dominant reasons for choosing dividend investing are emotional.

13 comments:

  1. In general, and especially in the short term, I'd agree that it doesn't matter too much one way or another.

    But over the long-term, if a company can't find a way to reinvest the cash, it should be paid out as a dividend so the investor can reinvest it. Now, that's a company-by-company analysis...

    Apple, for example, is one company that I can't understand for the life of me why it doesn't pay a dividend. Using rough numbers from memory, it's a ~$300 stock with ~$50 of cash. The operating company grows at say 20%/year, and generates yet more cash that just rots on the balance sheet.

    So you've got essentially a $250 stock growing at 20%, and a $50 cash tumor growing at 0%. If they paid out the cash in a dividend, you could reinvest it in Apple stock (or somewhere else) and get a return on that, but they don't. So instead of getting the full say 20% return of the operating company, you only get a 16.7% return on the shares.

    What I'm trying to say is that if a company hoards its cash flow, then you turn a potential compound growth situation into a linear growth one, and in the long term that's not going to be good.

    But yes, there's no point in a dividend for dividend's sake, if the company can reinvest the cash profitably.

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  2. @Potato: I agree that a given company may serve its investors better by correctly deciding whether or not to pay a dividend. However, I have no confidence that I can figure out which companies should pay a dividend, and I definitely don't believe that the typical dividend investor can figure out which companies are paying appropriate dividends.

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  3. I agree that a major benefit of dividends is emotional. And, given that most investment decision mistakes are emotional (especially herding, which causes market crashes), that's a benefit that shouldn't be discounted.

    You don't see the mathematical difference. That's based on the assumption that management wisely reinvests profits. I feel that may be the exception rather than the rule. But I can't prove that.

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  4. @Robert: I suppose that the emotional benefits people get from dividend investing may help prevent them from making emotional investing mistakes. Of course, some of them are already making an emotional mistake by tipping their portfolios towards dividends rather than capital gains, and others have overly concentrated portfolios. But these problems may be offset if dividends help people hold on when markets bottom out.

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  5. Your example is great in theory if the market is efficient, but with the stock that doesn't pay a dividend you don't "profit" from that 10% gain until you sell, which involves some market timing.

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  6. The impact of market prices is missing from your theory. If a company is paying out a rising stream of dividends, and you're spending that income, then you don't have to care about stock prices. If you're counting on selling 4% of your holding in a company's stock in order to pay the rent, you have to care a lot about stock prices. Clearly in this example I'm putting faith in that rising stream of dividends, which isn't assured. But historically, including the recent decade, stock prices gyrate a great deal more than cash dividends.

    I trust the businesses I'm buying shares of a great deal more than I trust the ability of the market to put a rational valuation on them. Sequence of returns matters, and assuming you can sell your equity at a good price when you need the income is putting a great deal of trust in market stability.

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  7. @Echo: If you are reinvesting dividends, this is a form of market timing as well. If you intend to replace collecting dividends with selling some shares, I don't see much difference if the stock sales are at the same time as the dividend payments would have been.

    @Matt: That's interesting. I suspect that this boils down to the theory that dividend stocks are less volatile. I suppose we could check out your idea on past market data. Perhaps it would be present with portfolios of just a few stocks. My guess is that if this effect is present, it would tend to disappear for broadly-diversified portfolios.

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  8. I'm always amazed by people who don't trust a company with retained earnings but trust the company with the initial capital that produced those retained earnings.

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  9. @Ahmed: Interesting take. I suppose there are situations where a company controls a profitable market that isn't growing and it doesn't make sense to retain earnings to try to start some new business. In general though, if you don't trust a business with retained earnings, you have to question whether you trust them with your capital in the first place.

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  10. I'm attracted to dividend-paying stocks because of the passive, secure income they provide in down markets. I feel big, large blue-chips offer some security that equity ETFs don't when things plunge 30%.

    That said, I own equity ETFs because I'm just not that smart to select, buy and hold all the right stocks that will provide security and growth for forever and a day.

    Back to the premise of your post, I personally get a kick out of any paid or reinvested dividend or distribution, bonds included. Probably makes me an oddball.

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  11. @My Own Advisor: Your reason for liking dividend-paying stocks seems to boil down to believing that they are less volatile, which may be true -- I'm not sure.

    I don't think I'm smart enough to pick individual stocks either.

    You are hardly an oddball. The premise of my post is that you are among the majority. There is nothing wrong with investing in a way that provides an emotional benefit as long as it doesn't overly harm long term returns.

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  12. Personally my experience has been that my dividend income has increased every year, but the value of portfolio has been very volatile at times.

    I stopped working in 1999 and have added no new money to my portfolio and I have found the same thing. My dividend income has only gone up. In recessions, the increase in dividend income is lower, but still I got an overall increase.

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  13. I like to say that if an investor holds the stock certificate, he can only receive the dividend by check, but if he owns the shares through a brokerage account or direct stock purchase plan with a dividend reinvestment option, he can choose to reinvest the dividends into additional shares of stock.

    ex dividend

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