Tuesday, November 14, 2017

The Dividend Puzzle

The strong preference many investors have for dividends over capital gains is known among economists as the “dividend puzzle.” Meir Statman offers a solution to this puzzle in his book Finance for Normal People.

Statman syas that many investors incorrectly “frame the capital of a stock as a fruit tree and dividends as its fruit. In that frame, collecting dividends and spending them does not diminish the capital of the stock any more than picking fruits off a tree and consuming them diminishes its size.”

“Rational investors know the correct frame for dividends and capital. They know that $1,000 in ‘homemade’ dividends from the sale of shares is identical in substance to $1,000 from a cashed dividend check, even if different in form, and they care about their total wealth, not its form.” Because the “price of shares of a company declines when a company pays dividends,” “payments of dividends do not affect the total wealth of investors.”

All that said, dividends do offer some advantages when we consider “expressive and emotional benefits” rather than just utilitarian benefits.


“Young investors bolster their self-control by setting separate mental accounts for income, including salary and dividends, and capital, including stocks. They add a rule—‘spend income but don’t dip into capital.’” Investors who create homemade dividends are more likely to succumb to temptation and “turn a 3 percent homemade dividend into a 30 percent homemade dividend.”

Sticking to a rule of not spending capital “also benefits older investors who draw money from their portfolios for retirement expenses and worry that self-control lapses would turn” their intended 3% home dividend into larger withdrawals.

Mental prohibitions against spending capital are so strong that when a company is forced to suspend its dividend, some shareholders living off dividends do “not even contemplate creating homemade dividends by selling [some] shares.”

Hindsight, Regret, and Pride

“Compare John, who buys a laptop computer for $1,399 with dividends received today from shares of his stock, to Jane, who buys the same laptop today with $1,399 homemade dividends from the sale of shares of the same stock.”

If the stock later goes up, Jane will feel regret for not having waited to sell, but John won’t feel this regret. Of course, if the stock later drops, Jane would feel pride for selling when she did, and John won’t feel this pride. “Consistent with loss aversion in prospect theory,” Jane would feel regret stronger than she would feel pride. So, on balance, John comes out ahead.


There is another emotional advantage to dividends that comes from the way that capital gains are framed with and without an associated dividend. This topic is somewhat technical, and so I’ll leave it to those who choose to read Statman’s book.

So, even though rational investors focus on total returns rather than over-valuing dividends, normal investors get some expressive and emotional advantages from dividends.

Friday, November 10, 2017

Short Takes: Amazon Nonsense, Extended Warranties, and more

I managed only one post in the past two weeks, a review of two books:

The Smartest Investment Book and Portfolio

Here are some short takes and some weekend reading:

Tom Bradley at Steadyhand is almost as cynical as I am about Amazon’s long, drawn-out “search” for a second headquarters location. I hope this whole PR event backfires for Amazon. In another article he discusses the elements of academic behavioural economics that he sees in practice.

Squawkfox has some sensible advice about extended warranties.

Gordon Pape shares important things you should know about traveling to Florida for the winter. His advice on this subject is far superior to his investment advice.

Big Cajun Man clarifies some of the rules surrounding Registered Disability Savings Plans (RDSPs).

Friday, November 3, 2017

The Smartest Investment Book and Portfolio

There is little doubt that the vast majority of investors would be better off investing in low-cost diversified index funds than attempting to beat the market. However, the best writers explaining this fact, like Charles D. Ellis, tend to be calm and reasonable, while the loudest proponents of expensive active management say silly alarmist things like “index funds will destroy capitalism.”

One voice on the index fund side that can take on hysterical active management proponents is Daniel R. Solin. His books The Smartest Investment Book You’ll Ever Read (Canadian Edition) and The Smartest Portfolio You’ll Ever Own pull no punches. While I prefer Ellis’s style, I like Solin’s chances of holding his own in a public debate.

Solin refers to active portfolio selection as “hyperactive management.” He says “The securities industry adds costs. It subtracts value.” He devotes many pages to the numerous failings of the investment industry. While he overstates some of his points (e.g., “Nobody Can Consistently Beat The Market”), most investors would do well to assume his absolutes are correct.

The 2006 book, The Smartest Investment Book You’ll Ever Read (Canadian Edition), is starting to get a little dated, but is still very useful. Many Management Expense Ratios (MERs) for index funds are now much lower, and there are more Exchange-Traded Fund (ETF) choices than there were back then. On the positive side, this Canadian edition really does have meaningful Canadian content.

The 2011 book, The Smartest Portfolio You’ll Ever Own, covers some of the same ground as the first book, but covers new ground as well. It offers several model portfolios. One ETF-based portfolio is essentially the same as the one recommended in the first book. Another portfolio is based on index mutual funds. A third is based on Vanguard target-date funds.

Solin calls these three model portfolios the “smartest portfolios.” To distinguish a fourth model portfolio from these three, he calls it “The SuperSmart Portfolio.” This portfolio is based on ETFs and is designed to capture size and value factors based on the Fama-French three-factor model. All four portfolios are intended for Americans, so Canadians will have to try to adapt them to investment choices available to us.

Here are a few interesting quotes:

“Wall Street is not completely lacking in skill. It takes considerable skill to convince you it has an expertise that doesn’t exist and that you should pay for this nonexistent skill.”

“Just say no to: Market timing; Buying individual stocks and bonds; Actively managed mutual funds; Alternative investments; Variable annuities; Equity indexed annuities; Private equity deals; Principal-protected notes; Currency trading; Commodities trading.”

“The true secret of giving advice is, after you have honestly given it, to be perfectly indifferent whether it is taken of not and never persist in trying to set people right.—Hannah Whitall Smith”

“If you are using a broker or adviser who claims to be able to beat the market, withdraw your money and close your account.”

Toward the end of the 2011 book, Solin gives somewhat of a commercial for Dimensional Fund Advisors (DFA), and he admits to being an advisor offering their funds. However, this comes after the bulk of the book that offers advice suitable for do-it-yourself investors.

Overall, I find these books useful for giving readers the indexing side of the active vs. indexing debate. Academics might cringe at the repeated absolutes, but the impact on readers is likely to be positive.