Trading Nation

Don’t buy into the dividend ‘fallacy,’ new academic paper warns

Investors committing the “free dividends fallacy”?
Investors committing the “free dividends fallacy”?

Dividends give equity investors a less risky way to make money. Dividends received from a stock don't count toward the gains or losses that were made by buying that stock. When bond yields rise, high-dividend stocks become less attractive.

These are just some of the misconceptions that many investors appear to have about dividends, according to a recent paper by Samuel Hartzmark and David Solomon entitled "The Dividend Discount."

At their root, the mistakes all come back to the original sin of dividend investing: considering dividend payments and capital gains in isolation. By doing so, investors either focus on dividends to the exclusion of potential capital gains and losses, or focus on capital gains and losses to the exclusion of dividends.

This effect of separating dividends from their source results in what Hartzmark and Solomon call "the free dividends fallacy."

"Investors are making a fundamental error in how they're thinking about dividends," Hartzmark, a finance professor at the University of Chicago, said Tuesday on CNBC's "Trading Nation." Investors "wrongly view dividends as additional income, rather than a shift of money from the stock price to the dividend."

Basic financial theory tells us that investors ought to be indifferent between seeing a company offer a dividend and seeing capital returned in other ways, such as through a buyback. Transaction costs and potentially disparate tax treatments add a bit of friction around this insight, but probably not much.

And it is no secret that a company's stock will tend to fall after a dividend is granted. (If it didn't, buying a dividend-paying stock the day before the payment is issued and selling it the day after would offer free money.) For this reason, dividend payments and short-term capital performance are opposed.

More to the point, for an investor looking to generate yield, selling shares of a stock ought to prove just as salient a strategy as receiving a dividend.

Yet to many investors, receiving a 2 percent dividend simply feels different than selling 2 percent of one's holding.

"Dividend irrelevance runs counter to intuitions from other areas of life, whereby harvesting the fruit from a tree is viewed as fundamentally different to harvesting the tree itself," said Hartzmark and Solomon, a finance professor at the University of Southern California.

The authors use a few interesting methods to capture the fallacy in the wild.

One of these relies on the finding that investors are more likely to sell a given stock at a gain than at a loss (a behavioral anomaly known as the "disposition effect"). While they did find evidence that individual investors are more likely to sell a stock that has appreciated in price than one that has depreciated, they found that investors are less likely to sell a stock that has only gained once dividends are included — a result "consistent with investors evaluating gains and losses using price changes."

Pursuing another line of inquiry, Hartzmark and Solomon find that when interest rates fall, demand for dividend payers rises. This seems natural enough — after all, if investors can't find suitable yield in bonds, they should look for it in stocks, right? However, this sort of thinking illogically treats dividend yield as an entirely distinct way of making money.

Interest-rate driven demand shifts suggest that "investors value these stocks as an income stream, and compare them to income streams on bonds and the potential for price increases."

And this, as well as pieces of evidence, "are best understood as showing that investors view price changes and dividends in separate mental accounts," the authors conclude.

The error could prove to be an expensive one. Investors who seek dividends in times of low rates "want dividends when everybody else wants dividends, and that pushes up the price and lowers the expected return," meaning that buying high-yielding stocks at such times "is a bigger mistake then just missing the trade-off," Hartzmark said Tuesday.

To take advantage of these investors' errors, the natural response would be to buy high-dividend stocks when they are cheap, and sell them when they are dear. In other words, buy high-yielders when bond rates rise, and sell them when rates fall — not despite, but because, this feels so unnatural.