Dangerous Devotion to Dividends
We often meet with investors who have an emotional devotion to dividends. This passion is generally built on misconceptions, aggressive marketing of “dividend-oriented products,” or just behavioral patterns and biases. They believe they are getting more financial security when, in fact, this infatuation may be hurting returns and increasing risk. As evidence-based investors, it is our responsibility to be objective and driven by data and research. The case against an overweighted devotion to dividends is quite compelling.
This short article references both old and more recent research on this subject. We provide links to the research if you have an interest in diving deeper.
Let’s start with some facts.
The Facts About Dividend-Paying Stocks
There is no such thing as a free dividend. A dividend just moves money from the stock price to a distribution. The focus should be on “total returns,” which captures both share price change and dividend yield.
In 1961 two professors (Miller and Modigliani) demonstrated mathematically that dividends were irrelevant to total returns. When a dividend is paid out, the stock price drops by the equivalent amount. This is a mathematical truism that isn’t disputed. In a world with decreasing transaction costs, this 50-year old study:
“Dividend Policy, Growth, and the Valuation of Shares,” Merton Miller and Franco Modigliani (1961)
A dividend-focused portfolio is less tax-efficient (and by extension, has lower after-tax returns).
While receiving dividends may feel good, you, unfortunately, must pay taxes annually if dividends received are in a taxable account, and they come whether you want them or not. A focus on capital gains, or what advisors call a “self-dividend,” is most optimal. It allows investors to be strategic about their year-to-year cash flow needs, opening the door for tax efficiency. And with today’s very low transaction costs, this approach comes with minimal consequences.
A portfolio focused on high-dividend yielding stocks (which is generally viewed as a “value strategy”) underperforms other well-documented value strategies.
Recent research from Mebane Faber of Cambria Investment Management and Wesley Gray and Jack Vogel of Alpha Architects looked at 40+ years of performance for dividend-paying stocks. Their research shows that while a dividend investment strategy outperforms the broader market, it lags other popular value strategies (such as those based on price-to-book or price-to-sales) by as much as 3% per year. That is big. The dividend approach did reduce volatility but also increased maximum drawdown risk, contradictory to what most investors believe. Their work shows that you are better off by NOT focusing on dividends and, instead, using other value-oriented strategies.
“Dividend Stocks are the Worst” by Mebane Faber
“How Much are Those Dividends Costing You?”
A portfolio focused on dividend stocks is less diversified, and therefore less efficient.
Not all stocks pay dividends. Only about 83% of S&P 500 companies do. Notably, some large companies like Amazon, Facebook, Netflix, Biogen, Alphabet, E*Trade and CarMax do not pay dividends. In addition, small companies are less likely to pay dividends. By focusing on dividend-paying companies, you exclude critical parts of the market and decrease diversification benefits. Given that dividend-paying stocks do not provide greater expected returns than other value strategies, this becomes a double whammy to investors (more risk, less return).
Current valuations for dividend stocks suggest they may no longer be an attractive value strategy.
A benefit to systematic value strategies is their continual reassessment of stocks to identify and reallocate into the most “valuey” companies. Today, those value stocks would be fewer and fewer dividend-paying stocks as investors have driven up the P/E, P/B and P/S of these companies, which in turn lowers expected returns.
Dividends are not guaranteed. And dividend reductions can cost investors significantly.
Just because a dividend has been paid out in the past, doesn’t mean it will continue. You’ve probably seen a disclosure on a financial report which says, “Past performance is no guarantee of future performance.” The same can be said for dividends. A great example of this happened this fall when General Electric (GE) announced that it was cutting its dividend in half. The stock price dropped 7% on one day. That was a big hit to current GE shareholders!
So why do investors retain a devotion to dividends?
The most likely reason is just misconception. And, hopefully, the above-mentioned research will help move some investors away from this bias. Yet, we know many won’t. Two studies really bring this home. A 1984 study by Shefrin and Statman, two well-known behavioral finance professors, provides multiple reasons for a misguided affinity for dividends. These range from ideas such as “prospect theory,” illusion of control,” and “regret aversion.” You can read more about these here:
“Explaining Investor Preference for Cash Dividends.” (1984) by Hersh Shefrin and Meir Statman
And more recently, in a paper from finance professors from the University of Chicago and the University of Southern California. Their work builds on the work from 1984 but provides more evidence and explanation for this devotion to dividends, particularly around the “free dividend fallacy.” Their conclusion was “investors buying dividend-paying stocks during times of high demand earn roughly 2-4% less per year in expectation.”
“The Dividend Disconnect” by Samuel Hartzman and David Solomon (2017)
Conclusion
Investing is difficult, and often made more difficult by our biases and misconceptions. We always need to watch out for when emotions are driving our decisions versus data and evidence. In this case, the evidence against an over-weighted, dividend-focused investment strategy is fairly solid. Yet, overcoming our biases is another challenge. That is where a good evidence-based adviser can help you. If you have questions or need assistance, contact us.
