Dividends Feel Like “Free Money,” But They’re Not
Chapter 12 of The Rational Investor
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The rational investor cares about one thing; total investment returns.
Total returns for stock market investors = capital gains + dividends - investment fees & taxes
All that matters is, what is my account balance? If you have a $100,000 portfolio, the $100,000 is all we should care about. We shouldn’t care whether that $100,000 came from dividends or capital gains (increase in share prices).
Except most people care. They care a lot.
Investors love using dividends to buy stuff
A 2021 paper titled “consuming dividends” written by Konstantin Bräuer (University of Frankfurt), Andreas Hackethal (University of Frankfurt), and Tobin Hanspal (Vienna University) examined why investors are drawn to dividend-paying stocks and how some investors plan their entire financial life around dividends1.
The Researchers used bank data, portfolio data, and survey data to measure how investors’ spending habits changed around days of receiving dividend income from a portfolio. Their findings show that many investors allowed their spending to be dictated by the dividend policies of the companies they invest in.
Finding #1: Investors are significantly more comfortable spending dividends than their paycheck.
14.4% of dividends an investor receives are spent on one-off purchases within a week. The majority of that spending occurred on the day they received the dividend.
Only 9.6% of labor income was spent on similar purchases within the same period.
Finding #2: Dividend bias exists for the young & old and the rich & not-so-rich.
Increased consumption around dividend payments is significant across wealth and age distributions.
Finding #3: Supersavers are the most reliant on dividends to fuel their spending
Past research has suggested that those who rely on dividends lack self-control in their spending habits.
This study finds the opposite result; “those who would prefer to save rather than spend, consume a larger fraction of their dividend income precisely around days of its arrival.
Those who actively plan their finances consume a much greater share of dividends they receive compared to those who don’t have a financial plan. This finding suggests that investors intentionally rely on dividends to pay for their cost of living as a key pillar in their financial plan.
Finding #4: 61% of respondents view dividends as expected income like a salary or work bonus.
Investors who think of dividends as expected money spend a greater proportion of the dividends they receive.
Here’s a simplified summary of these findings: People tend to feel extremely comfortable spending dividend money, even more than spending money from their paycheck. This is not an accident but a central component of their financial plan to pay for their cost of living with dividend income.
Dividends feel like “free money,” but they’re not
To the rational investor, it doesn’t matter if returns come from capital gains, dividends, or some combination of the two.
If you want to buy tickets for a concert that add up to $500, the tickets will still cost you $500 of your portfolio whether you choose to make the purchase using dividends or by selling a few shares and using capital gains.
Income is income.
However, most investors are not rational, and they have a firewall in their minds that separates dividends from capital gains.
Dividends are viewed as “real” money that can be spent.
Capital gains are viewed as “temporary” money that should not be touched.
The real reason we prefer to spend dividends and sit on capital gains is that we are afraid that selling shares to fuel consumption will lead to a situation where we run out of money. The dividend investor feels safe because they are not “touching their principal.”
This type of thinking is a fallacy.
When companies issue dividends, the value of the company goes down. A mathematical fact that even sophisticated investors ignore.
If a company is holding $100 million in cash from profits, it has two options.
Retain the $100 million.
Payout $100 million in dividends.
If the company pays out the $100 million in dividends, it just gave away $100 million in assets, and—all else equal— the value of the company falls by $100 million. It’s basic math that dividend investors choose to ignore.
This reality is expertly explained in a 2018 paper titled “The Dividend Disconnect,” in which authors Samuel Hartzmark (University of Chicago) and David Solomon (Boston College) examine the reasons investors have a disconnect between dividends and capital gains.2
Hartzmark and Solomon refer to the popular (and wrong) perception that dividends are stable and secure in times when the stock market is crashing as “the free dividends fallacy.”
The primary reason for the widespread belief in the free dividend fallacy is that the price of stocks is extremely visible and easy to access. You can open your phone and see the change in the price of a stock second by second. Most investors only find out about a change in a company’s dividend policy when a press release is issued (that the investor probably won’t read) or when the dividend payment they receive is suddenly smaller than what they expected.