Enrich Your Future 30: The Hidden Cost of Chasing Dividend Stocks

In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. In this series, they discuss Chapter 30: The Economically Irrational Investor Preference for Dividend-Paying Stocks.LEARNING: The dividend policy is irrelevant to stock returns.&nbsp;“Stock prices tend to rise in the month before they pay the dividend, because dumb retail investors overvalue dividends, and then they tend to revert back after the dividend gets paid.”Larry Swedroe&nbsp;In this episode of Enrich Your Future, Andrew and Larry Swedroe discuss Larry’s new book, Enrich Your Future: The Keys to Successful Investing. The book is a collection of stories that Larry has developed over 30 years as the head of financial and economic research at Buckingham Wealth Partners to help investors. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss Chapter 30: The Economically Irrational Investor Preference for Dividend-Paying Stocks.Chapter 30: The Economically Irrational Investor Preference for Dividend-Paying StocksIn this chapter, Larry discusses why many investors prefer cash dividends, especially those using a cash flow approach to spending.Larry explains that experts have established that dividend policy should be irrelevant to stock returns, which is supported by historical evidence. Stocks with the same exposure to common factors (such as size, value, momentum, and profitability/quality) have had the same returns, whether they pay dividends or not. Despite theory and evidence, many investors express a preference for dividend-paying stocks.The fallacy of the free dividendAs Larry explains, investors tend to assume that dividends offer a safe hedge against the large price fluctuations that stocks experience. However, this assumption ignores that the dividend is offset by the fall in the stock price—the fallacy of the free dividend is a common misconception in the investment world.Larry adds that stocks with the same “loading,” or exposure, to the four factors (size, value, momentum, and profitability/quality) have the same expected return regardless of their dividend policy. This has important implications because about 60% of US and 40% of international stocks do not pay dividends.Thus, any screen that includes dividends results in far less diversified portfolios than they could be if they had not included dividends in the portfolio design. Less diversified portfolios are less efficient because they have a higher potential dispersion of returns without any compensation in the form of higher expected returns.Taxes matterLarry notes that what is particularly puzzling about the preference for dividends is that taxable investors should favor the self-dividend (by selling shares) if cash flow is required. Taxes play a crucial role in investment decisions, and understanding their implications is essential for making informed choices.Even in tax-advantaged accounts, investors who diversify globally (the prudent strategy) should prefer capital gains because the foreign tax credits associated with dividends have no value in tax-advantaged accounts.Why do investors still prefer dividends?Hersh Shefrin and Meir Statman, two leaders in behavioral finance, attempted to explain the behavioral anomaly of a preference for cash dividends. The first explanation is that, in terms of their ability to control spending, investors may recognize that they have problems with the inability to delay gratification.To address this problem, they adopt a cash flow approach to spending—they limit their spending to only the interest and dividends from their investment portfolio. In other words, the investor desires to defer spending but knows he doesn’t have the will, so he creates a situation that limits his opportunities and, thus, reduces the temptations.The prospect theoryThe second explanation of why investors prefer dividends is based on “prospect theory.” Prospect theory states that people value gains and losses differently. As such, they will base decisions on perceived gains rather than losses.Thus, if a person was given two equal choices, one expressed in terms of possible gains and the other in potential losses, they would choose the former. Because taking dividends doesn’t involve selling stock, it’s preferred to a total return approach, which may require self-created dividends through sales. The reason is that sales might affect the realization of losses, which are too painful for people to accept (they exhibit loss aversion).Further readingMerton Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of Business (October 1961).Hersh Shefrin and Meir Statman, “Explaining Investor Preference for Cash Dividends,” Journal of Financial Economics (June 1984).Did you miss out on the previous chapters? Check them out:Part I: How Markets Work: How Security Prices are Determined and Why It’s So Difficult to OutperformEnrich Your Future 01: The Determinants of the Risk and Return of Stocks and BondsEnrich Your Future 02: How Markets Set PricesEnrich Your Future 03: Persistence of Performance: Athletes Versus Investment ManagersEnrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?Enrich Your Future 05: Great Companies Do Not Make High-Return InvestmentsEnrich Your Future 06: Market Efficiency and the Case of Pete RoseEnrich Your Future 07: The Value of Security AnalysisEnrich Your Future 08: High Economic Growth Doesn’t Always Mean High Stock Market ReturnEnrich Your Future 09: The Fed Model and the Money IllusionPart II: Strategic Portfolio DecisionsEnrich Your Future 10: You Won’t Beat the Market Even the Best Funds Don’tEnrich Your Future 11: Long-Term Outperformance Is Not Always Evidence of SkillEnrich Your Future 12: When Confronted With a Loser’s Game Do Not PlayEnrich Your Future 13: Past Performance Is Not a Predictor of Future PerformanceEnrich Your Future 14: Stocks Are Risky No Matter How Long the Horizon<a href="https://myworstinvestmentever.com/enrich-your-future-15-individual-stocks-are-riskier-than-you-believe/" rel="noopener...