Many investors, especially those who use a cash flow approach to expenses, prefer cash dividends. From the perspective of classical financial theory, this behavior is an anomaly.
In their 1961 paper Dividend policy, growth and stock valuationMerton Miller and Franco Modigliani famously proved that dividend policy should be irrelevant to stock returns.
As they explained, at least before frictions such as trading costs and taxes, investors should be indifferent between $1 in the form of a dividend (causing the stock price to fall by $1) and $1 received from the sale of shares. This must be true unless you believe that $1 is not worth $1. This theorem has not been challenged since.
Furthermore, historical evidence supports this theory – stocks with the same exposure to common factors (such as size, value, momentum and profitability/quality) have the same returns regardless of whether they pay dividends or not. However, many investors ignore this information and express a preference for dividend-paying stocks. The main explanation for this preference is the “free dividend fallacy” – investors fail to understand that dividends are not free money, but come directly at the expense of the stock price.
Despite empirical evidence showing that receiving a dividend should be irrelevant to investors, there is a big BODY e literature documenting that many investors treat dividends differently from other sources of payments, leading to suboptimal performance. Can investors be educated to avoid the mistake of treating dividends differently? Andreas Hackethal, Tobin Hanspal, Samuel HartzmarkAND Konstantin Brauerauthors of the May 2024 study Educating investors about dividendsattempted to answer this question using an interactive quiz that educated investors on the economically sound financial intuition of dividend thinking.
They began by noting that “the free dividend fallacy is likely rooted in ignorance, suggesting that education may moderate the bias. Such behavior is costly, as it usually leads to underperformance through lack of reinvestment, higher taxes, and buying overpriced stocks when dividend demand is high.
To help investors understand the mistake and avoid these costs, in 2021, the authors collaborated with a large German bank. “Germany is an ideal location for our intervention as German firms tend to pay a large annual dividend in the spring, making payments large and prominent. In addition to allowing us to randomize investors into treatment groups, the bank provided data on trading behavior from before and after treatment.” They added: “The current tax regime in Germany is such that investors should not have a preference for dividends over capital gains.”
They wanted subjects to understand that dividends came at the expense of the stock price. Thus, the investor should neither consume nor treat them differently from the share price valuation. Participants were sent an email outlining the basic logic behind the no-dividend (when dividends are paid, firms' share price normally decreases by the amount of the dividend) and an example using the DAX Index that illustrates the large difference in performance with and without a dividend. reinvestment. The email explained that “investors trying to achieve total return index performance should reinvest rather than consume dividend payments.”
“Investors were asked to click on a link to learn more and take a survey in exchange for a €10 gift card. The survey included further information and a short interactive quiz to try to solidify the concepts and underline these messages. Some investors were randomized to a zero-touch group and received no communication.” Their sampling procedure resulted in a pool of 8,327 investors, 6,637 investors who received a placebo treatment email and an invitation to a survey about dividends via an email with the same subject but which did not explain the benefits of dividend reinvestment, and a over. -Sample group of 21,023 investors who received the reinvestment email.
The first question posed to survey subjects was, “What generally happens to a stock's price just before a dividend is distributed to investors?” Investors can choose: a) The share price falls by about the amount of the dividend, b) Nothing, c) The share price rises slightly, or d) Not sure. “Whether the investor chose the correct option (choice A) or the incorrect one, they saw an intuitive explanation describing why the price decreased. He stated that if the dividend is still part of a firm's balance sheet, it is reflected in the share price. When the dividend is paid, it is transferred from the company to the investor and is therefore no longer included in the company's share price. What does this mean for investors? Dividends are not 'additional income' because they come directly from the share price. After dividend payments, investors are usually as rich as before.”
The second question gave the approximate level of the DAX index in March 2021 of 15,000 (which includes dividend reinvestment) and asked what level they think it would have been without dividend reinvestment. The correct answer is about 6500 points.” The accompanying explanation concluded: “Anyone who has withdrawn and spent all the dividends from the DAX companies since 1988 has only half as much in equity assets today.”
The third question asked whether an investor should care whether the money came from dividends or from a stock sale (a self-made dividend). “The effort was to point out that if investors didn't want to take a take-home dividend, they should want to reinvest a received dividend.” The explanation concluded: “If a partial sale is not desired, reinvestment must be done.”
After the three questions, they had a lessons learned section. The section said, “To summarize: Dividends are not 'additional income' because they are deducted directly from the share price. If the dividends are not reinvested, this is comparable to a partial sale of shares… So, if you want to take full advantage of compounding and realize the full performance of an investment in securities, you must reinvest the dividends in securities. “
Here is a summary of their key findings:
Investors' plans to reinvest some of their dividends increased by approximately 10 percentage points (statistically significant at the 1% confidence level) for those exposed to the reinvestment treatment message compared to the placebo treatment. Investors who received the reinvestment treatment, on average, increased the fraction of dividends they planned to reinvest by 8 percentage points compared to the average reinvestment fraction declared before the treatment of 38 percentage points.
Investors who were exposed to the reinvestment treatment were also 20 percentage points more likely to choose a fund that automatically reinvests rather than distributes and 13 percentage points more likely to state that they would prefer their dividends to be automatically reinvested .
Investors with low quiz scores, “perhaps those who got the most out of handling the information,” increased their reinvestment purchases by more than those who answered all the quiz questions correctly. Further, investors who gave incorrect answers to the dividend quiz, who stated that they learned something new or found the information informative, increased their reinvestment behavior by a significantly greater amount than other participants.
The effectiveness of the “treatment” continued over the following two years, with a positive effect on portfolio values - “while we cannot definitively rule out that consumption remained the same, the evidence is consistent with increased reinvestment and a lack of increased consumption from others. resources that lead to increased savings.”
Their findings led the authors to conclude: “Our findings suggest that the free dividend fallacy is likely to be an important driver of dividend demand…. Our finding suggests that some financial decisions can be improved with a targeted intervention.”
Given that dividends are at a tax disadvantage in the US for taxable investors (the full amount of the dividend is taxed, while only the profit resulting from a take-home dividend (from the sale of shares) is taxed), a behavioral requirement for dividends results in higher costs than in Germany.
Investor Relations
Advisors can help investors achieve better results by helping them better understand the relationship between dividends and stock price changes. By doing so, investors will be able to characterize the gains from each appropriately and avoid some of the negative consequences that can result from this anomaly.
Larry Swedroe is the author of 18 books, the latest of which is Enrich your future: the keys to a successful investment.