Monday, October 19, 2015

How Dividends Affect Stock Prices

A few times now I’ve seen dividend investors claim that paying dividends doesn’t make stock prices drop. The claim is that investors know the dividends are coming and they are already built into the price of the stock. This isn’t true, but perhaps the reason isn’t obvious. After all, this type of reasoning does make sense with other types of news about stocks.

This is best explained with an example. Consider two companies:

Company A
– will be paying a $1 per share dividend tomorrow

Company B
– won’t be paying a dividend
– will be paying a fine tomorrow that works out to $1 per share

In both cases, we assume that investors have known about these facts for a long time. In company B’s case, when tomorrow comes and they have to pay the fine, their stock price changes no more than usual because investors have known about the fine for a long time and have already factored it into company B’s share price.

So, the question then is why doesn’t this logic apply to company A? After all, their situations look quite similar. But, when company A’s shares trade ex-dividend (meaning that the share buyer won’t get the dividend), the share price drops by $1. Why the difference?

The answer comes from examining exactly what investors are buying today versus tomorrow. In company B’s case, if I buy today and hold until tomorrow I’ll have the same thing as if I wait until tomorrow to buy. In both cases I’ll have shares of a slightly poorer company B.

In company A’s case, if I buy now and hold until tomorrow I’ll have the slightly poorer company A plus a dollar per share. If I wait until tomorrow to buy company A’s shares, I won’t get the dollar per share. So, company A’s shares are more valuable to me today than they will be after the dividend gets paid.

A factor that makes this difference less obvious is that dividends amounts are usually small compared to stock prices. The natural volatility of stock prices masks the share drop caused by paying the dividend.

Another factor masking this effect is that most dividend-paying companies have enough earnings to justify their dividends. So their profits make their shares more valuable over time. This means that share prices tend to build up through each quarter as profits are earned.

If we could remove the market’s volatility, we’d see a saw tooth pattern with share prices rising steadily for 3 months and then dropping suddenly when the dividend is paid. But market volatility and investor behaviour mask this pattern.

Don’t get caught up in magical thinking. You can’t take money out of a piggy bank and expect it to still hold the same amount.

25 comments:

  1. Well stated, however, I look forward to the fire storm of Dividend investing zelaots telling you how wrong you have it. Dividends are good (I hear).

    Put on your asbestos undies

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    1. @Big Cajun Man: The funny thing is that I look forward to my dividends each quarter just like many other investors. But I don't think they're magic.

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  2. I don't think they are magic, but they are less volatile than capital gains.

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    1. @Gary: Very true. Dividends are driven by earnings. Over the long run, capital gains are driven by earnings as well, but over shorter periods, other factors can drive capital gains. A big virtue of dividends is that they keep an investor's eyes off meaningless short-term stock price swings.

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  3. Good post but I often wonder if some dividend zealots over complicate things...

    When a company pays a dividend, as you pointed out, the market may account for that dividend preceding the ex-div date by a rise in the price of the stock. This is because buyers are willing to pay a premium to receive the dividend. However, on the ex-div date, the exchange automatically reduces the price of the stock by the amount of the dividend. This normalizes the playing field.

    The short-term fluctuations of stocks are meaningless anyhow, with or without dividends. I can attest dividends help me, they provide me with extra willpower to stick to my plan and avoid selling anything when things get rough.

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    1. @Mark: I think it's a case of dividend investors perceiving the fact that stock prices drop when dividends are paid as some sort of disadvantage of dividends that must be willed away somehow. But it's not a disadvantage. It's just a case of investors being paid some of their share of earnings. I'm definitely with you on the meaninglessness of short-term fluctuations.

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  4. I think Gary's comment about dividends being less volatile than capital gains is a major behavioural reason why dividend paying stocks are so popular. It makes them feel safer. There is a feeling that if some of a non dividend paying stock is sold that the investment is partially gone forever. Yet when a dividend is received, there is no impairment of the investment. I think that feeling comes from the higher volatility of capital gains, the stock may drop and maybe not recover, whereas dividends are much less volatile, so feel safer. Ironically, a focus on dividend paying stocks usually leads to a less diversified and therefore riskier portfolio.

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    1. @Grant: I think the appeal of dividend investing may even be simpler than this in many cases. It feels good to receive cash dividends and this drives people to seek stocks with higher dividends. But this sounds unsophisticated, so elaborate justifications ensue. But I agree that your explanation applies in many cases as well. I think it's possible to have a reasonably well diversified dividend portfolio if you include U.S. stocks, but many so-called dividend investors just own a couple of Canadian banks.

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  5. I only hold Canadian Stocks because of the dividend tax credit not because of a magical belief in magic.
    This is a bird in the hand is worth more than two in the bush story.

    As you point out, the decline is caused by investor psychology not so much by company specifics.

    This is why I have always maintained and argued that when you buy a single security you are gambling. You are placing a bet that you are smarter than the whole market and the security you bought will rise higher and faster than the market.

    You're a speculator if you buy stocks, you're an investor when you buy the market.
    That is why the short term fluctuation at the ex-divi date, gamblers want their money and sometimes the stock plunges. Individual stocks are volatile, this is why I combine them with broad market ETFs.
    It offsets my gambling addiction to dividends!

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    1. @Peter: If you decide that your Canadian stock are collectively not diversified enough, you could add something like VXC. I have to disagree with you on the reason for the decline. It is very rational and has nothing to do with investor psychology. I'm willing to pay $10 more for a dresser with a $10 bill in a drawer than I would pay after the $10 bill is removed. This is true even if I expect a new $10 bill to appear in the drawer every 3 months.

      I'm definitely with you when you say that owning a single security is gambling. I also understand the addiction to dividends. It just feels good every 3 months when I get paid.

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  6. Good explanation Michael.

    I view dividend investing the same way and I also look forward to my quarterly dividends. They "feel" good.

    I moved from a dividend approach to an indexing approach for my equity investments in retirement. I confess it is tempting to put some of my FI portion into dividend payers-for the relatively steady "income".. Although if we decide to accept the equity risk it likely makes more sense to simply increase our ratio somewhat with existing equity broad market ETFs, and continue with a total return approach.

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    1. @RBull: Glad you liked it. I hope your retirement income remains steady.

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  7. "dividend investors claim that paying dividends doesn’t make stock prices drop"

    This is a straw man argument. You do not have a representative sample to prove your statement.

    The article supports your existing comical biases against dividend investing, and it also makes you feel better about yourself.

    When you call someone a zealot, you instantly lose credibility

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    1. @Anonymous: Nice cherry-picked quote. The preceding few words are "A few times now I’ve seen". My goal is to explain to those who believe dividends don't make stock prices drop that they are mistaken. Your ad hominem attacks are nonsense.

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  8. I love how you answer comments.

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    1. @Kerry: Thanks. I try respond to each one as a separate conversation from the others.

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  9. Umm.. the price of the stock decreases by the same amount of the dividend because the exchange reduces the price by that much - not the market.

    Do you not know this?
    If you do, then not mentioning it was intellectually dishonest.
    If you did not, then you are too ignorant, by definition, to comment on it intelligently.

    Cheers

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    1. @Anonymous: So, the world's investors are all just hapless dummies and the exchanges control all stock prices? That's ridiculous. If exchanges didn't reduce stock prices after a dividend, it would create an arbitrage opportunity that would force the price to move.

      Exchanges are slaves to the world's investors, not the other way around. It's tempting to repeat your nonsense and ask you if you were dishonest or stupid in not saying this in the comment, but such things serve no useful purpose.

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  10. Well you can choose to get angry if you like - I prefer to deal with facts. The Exchange literally reduces the price of the stock - not the market. That is a fact. I don't know what would happen if they did not and neither do you.

    Cheers

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    1. @Anonymous: Based on this logic, it's the exchanges that control all stock bid and ask prices; investor trade requests have nothing to do with it. Utter nonsense.

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  11. So you agree with the fact that the exchanges artificially reduce the price of a stock on the ex dividend date?

    If so, you should really explain how this works in an article detailing what effect dividends have on stock prices, n'est ce pas?

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    1. @Anonymous: I explained why a drop in stock price after paying a dividend makes sense and is in no way artificial. I'm sorry you're unable or unwilling to understand.

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  12. Hi Michael,

    I have been pretty busy and able to only comment rarely on my favorite blogs. (catching up) I see we are still in the same argument that we were in 1-2 years ago...
    Why can't we all just get along? Aren't we all on the same journey.

    If "Anonymous" was so confident about his comments, why would he not link himself to his blog? Goes back to my "protecting a brand" comment rather than acknowledging reality.

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    1. @Paul: Every approach to investing has advantages and disadvantages. I've chosen index investing because I think it is likely to give me the best results netting out the advantages and disadvantages. Dividend investors come to a different conclusion. Reasonable dividend investors acknowledge that pluses and minuses exist, but they think the net works out better for them with dividend investing. Sadly, some dividend investors deny that anything that sounds like a disadvantage exists. I guess the obvious fact that stock prices must drop after paying a dividend sounds like a disadvantage that can't possibly exist in their world.

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  13. No one has to look at it like a disadvantage really. It's a nice clean way to invest. You have 20 dividend payers, you get a bunch of nice little dividend payments that give "instant gratification moments" every month or quarter. Set up right you can get small discounts on your dividend reinvestment's. I get it.

    I still think that Div-investing can even attract beginners into investing. The constant dividends may help them keep their interest and focus. It's how I started. Hell, I still own a fund (I know... high fee's and everything) that this month will "distribute" $350.00 in December, that has had a decent long term return. Next month it will be $352.80, then about $356.00 in February... Yes it's addictive. But I don't close my mind to other investments. Nor do I try to argue with you or anyone else as to whats the "ultimate" form of investing.

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