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.


  1. Interesting way of looking at it, and I very much agree. I like the fruit tree analogy especially because even though I understand the mechanics of dividends, I have often caught myself thinking this way.

    I assume it was noted in the book that there also can be a significant difference in tax treatment of dividends vs. capital gains, which could be a deciding factor for some. Perhaps this was out of scope of the post above.... but it bears noting as such as I think this would be something that many in the "pro dividend" camp are likely to note & hang their cap on.

    1. @Anonymous: Taxes are discussed in the book as even more reason for the puzzle of preferring dividends. I chose not to discuss taxes because most people don't use all of their RRSP and TFSA room.

    2. Also, foreign stock paying high dividend may lead to significant tax impacts even within registered accounts.

  2. Except that this drives investors to focus on buying dividend stocks and diminishes expected returns. In a way this is a decency bias. There were times when most investors focused on growth stocks and didn’t want dividends. And yes, recently dividend stocks ha e done well.

    1. “Recency”. Autocorrect...

    2. @BHCh: Reduced expected returns is a side effect of any attempt to get expressive and emotional benefits instead of just seeking financial returns. This isn't necessarily bad if you do it with your eyes open. The problem comes when you satisfy expressive and emotional needs but try to delude yourself that you're not sacrificing financial returns.

    3. "decency bias" - a preference for stocks that have had decent returns.;-)