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.

Self-Control

“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.

Framing

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.

18 comments:

  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.

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    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.

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

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  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.

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    1. “Recency”. Autocorrect...

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    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.

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

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  3. If I have 95 shares of RY and use that irrational dividend for income (the book calls me irrational!) then at the end of 10 years of retirement I still have 95 shares. If, instead, RY pays no dividend and I have to sell 5 shares to create my own dividend then soon I won't have any shares of RY! Why is the second approach better in retirement?

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    1. @Anonymous: You're making the mistake described in the second and third paragraphs of this article. If RY didn't pay a dividend, it's shares would rise in price faster. Because it's highly unlikely RY could invest all of its profits at a reasonable return, I'll describe an alternative scenario with stock buybacks.

      Suppose that RY used its profits to buy back shares instead of pay dividends. This would make RY shares rise in price faster. You'd sell 5 shares the first year, but your remaining 90 shares would be worth roughly the same as 95 shares are worth in the dividend-paying scenario. After a few years, you'd only need to sell 4 shares, then a few years later, only 3 shares. After a decade, you'd have fewer shares of RY, but each share would be worth so much more than the dividend-paying scenario that your principal would be the same.

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    2. Well said. I am also 10 years retired. I still have all the stocks I retired with. But I do sell some from time to time to reap the capital gains, pay the taxes, and then simply re-purchase them.

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  4. Thanks for the quick answer. Companies that have excess 'cash' often do other things. RY is no exception and has made acquisitions in the USA in the past with this excess 'cash'. Forays into another country can go bad for many reasons and have for RY in the past when they had to retreat from those USA acquisitions and sell them at a loss. I would rather buy 'mature' companies who are more conservative with their excess 'cash' and reward shareholders rather than stay 'growth' companies and make unwise acquisitions and often overpaying!
    The scenarios that you describe (share buybacks) & retaining cash in the company making the share value rise are ideal, but during black swan events bear markets can last 5-10 years. Share values plummet, but mature companies like RY do not reduce or suspend dividend payments. During the accumulation phase one has capital capacity to purchase these bear market buys but those of us in retirement can not. We need income and so we are forced to sell falling equities! Am I missing something?

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    1. @Anonymous: Yes, you are missing something. In a scenario where stock prices are plummeting, RY share buybacks would be more valuable, offsetting the fact that you'd be selling shares. So, the two approaches are still equivalent.

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    2. You are not retired and so buybacks work better for you. Buyback increases in share value may happen over time, yes, but the amount is never predictable therefore causing more anxiety for a retiree. During that interval much can happen to a company. Dividend payments happen regularly, more predictably, and are a bird at hand with little effort or cost. Hence, more useful when you are retired.
      Now. regarding a bear market lets look at what happened November 2007 to the first week of March 2009, when global equities endured one of the biggest bear markets on record? During this period, the Buyback Index slumped 53.32%, while the Dividend Aristocrats held up better, with a decline of 43.60%. The S&P 500 tumbled 53.14% during this period. During that period my income based on interest + dividends didn't change. Selling into that bear market particularly the S&P 500 would have been painful!

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    3. @Anonymous: You're now comparing RY to other stocks rather than comparing RY to a hypothetical version of itself that does stock buybacks. You're essentially saying that RY is a better stock than average. If this is true, it has nothing to do with the dividend it pays; it has to do with RY's profitability.

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  5. Yes, RY and true it is a profitable company but an irrational one if Statman's diagnosis of its shareholders is correct. Why don't RY's managers educate the shareholders to convince them that buybacks are more rational? One reason is that shareholders don't have all the information that managers do and so shareholders don't always trust them to make the wisest decision regarding surplus cash. Shareholders know that they can have it both ways! Historically it's true that stock prices go up following unexpected dividend increases and fall after unexpected dividend decreases. Shareholders then can have both dividends and capital gains. But, if the economy turns and surplus cash drops shareholders can still pay for their retirement with RY's dividends. And RY dares decrease that dividend because then share price will drop twofold. Shareholders are more rational than Statman gives them credit for.

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    1. @Anonymous: This is nonsense. Over the long run, RY's total returns will be driven by their profits. There is no magic way to "have it both ways." It's impossible for RY's capital gains plus dividends to outgrow earnings over the long run. Paying dividends rather than buying back stock causes lower future capital gains. It's not that stock buybacks are better (except possibly tax-wise); it's that they have the same effect on total returns as paying dividends.

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    2. Our discussion or whatever it was is over! Your don't get it so you resort to personal attack calling my opinion "nonsense". Realize that then you are saying RY shareholders are nonsensical because they don't adhere to your mantra! They are far from nonsensical!

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    3. @Anonymous: We're not talking about matters of opinion like food preferences. What you said didn't make sense. I never said "RY shareholders are nonsensical" and my arguments are not a "mantra." Owning RY makes sense if it has an expectation of producing higher future earnings than expected based on the current stock price. The split between dividends and capital gains is irrelevant.

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