# The Free Dividends Fallacy



## Sarenco (27 Jun 2017)

Excellent article in today's Irish Times on the irrational preference of investors for shares with high dividend yields:-

http://www.irishtimes.com/business/personal-finance/yield-hungry-investors-fall-for-free-dividends-fallacy-1.3134518


"_Interest rates have been on the floor for years, prompting frustrated and yield-hungry investors to turn to dividend stocks. There’s a problem, however: research indicates many investors make costly errors because they don’t actually get how dividend investing works.

Do you? To test, state if the following statements are true or false:

(A) Dividend-paying stocks are less risky than non-payers;

(B) Like bonds, they offer free annual income as well as the potential for capital growth;

(C) Dividend stocks are an especially good investment when bond yields are low, like today.

Kudos to those who answered false. Those who didn’t may be guilty of what researchers call the “free dividends fallacy”. 

Consider a company whose shares are priced at €1. It decides to pay its investors a 3 per cent dividend annually. On the date the dividend is due, the company will distribute €3 to a shareholder with 100 shares and the share price will drop by the amount of the dividend paid, to €0.97. What’s the difference between this and a non-dividend paying company whose share price remains at €1 throughout? 

If the above investor with 100 shares wanted income, he could simply sell three shares – in essence, create a home-made dividend. It should make no difference whether he receives €3 in the form of a dividend or by selling shares – in both cases he is left with €97 of shares and €3 of cash. Investors who prefer high-yielding dividend stocks do not tend to think this way, indicating they may not be grasping dividend payouts trigger an equivalent decline in the share price." _


----------



## Jim2007 (27 Jun 2017)

Sarenco said:


> _Kudos to those who answered false. Those who didn’t may be guilty of what researchers call the “free dividends fallacy”._



Or the researchers might be talking a lot of crap (in my opinion)!!!  It is not in the interests of the shareholder for the company to retain earnings if it cannot deliver at least as good a return as the investor could get else were.  There are some companies who are cash cows and it makes since to consider such stocks in an income generating portfolio.  For example  I invest in title insurance companies for their income - because they are required to be a mono line insurance company they have little opportunity to grow and retained earnings will not generate much of a return going forward, but they are excellent cash generators.


----------



## Sarenco (27 Jun 2017)

Jim2007 said:


> It is not in the interests of the shareholder for the company to retain earnings if it cannot deliver at least as good a return as the investor could get else were


Sure but that's not the point being made in the article.

If your cash rich companies simply bought back your stock you would be in the same economic position.  Take taxes into account and you would actually be in a better position.

There is nothing magical about dividends as compared to capital gains - it's an irrational preference.


----------



## galway_blow_in (27 Jun 2017)

maybe im just stupid but ive heard this before and it makes no sense to me

the author of the piece claims that in the case of a stock which pays 3 dollars of a dividend , on ex dividend day when the price of the stock drops by 3 dollars  , this makes the dividend a fallacy

he is to me simply using the natural price fluctuation of stocks as a way of pushing him his bogus point about dividends being of no real NET  benefit , using the arguement to its full wide conclusion , if a stock which eventually reach three dollars were to remain at below the purchase price of say a dollar , for several years , it would be no use even it did get to three dollars at some stage

dividends to me are about being paid to wait for ( hopefully ) capital appreciation , houses also fluctuate in price , while the stock does reduce in price to account for each quarterly dividend payment , its not like it remains down or as if some of your original holding has been reduced in order to pay out the cash dividend


----------



## Sarenco (27 Jun 2017)

galway_blow_in said:


> his bogus point about dividends being of no real NET benefit


No, that's not the point being made - I don't think anybody would suggest that dividends aren't a significant component of the total return on stocks. 


galway_blow_in said:


> dividends to me are about being paid to wait for ( hopefully ) capital appreciation


That's just mental accounting.  Just because you like to think of it like that doesn't make it so.


----------



## galway_blow_in (27 Jun 2017)

Sarenco said:


> No, that's not the point being made - I don't think anybody would suggest that dividends aren't a significant component of the total return on stocks.
> 
> That's just mental accounting.  Just because you like to think of it like that doesn't make it so.



well i guess im just stupid then , is rent each month on a BTL the same ?


----------



## Sarenco (27 Jun 2017)

galway_blow_in said:


> well i guess im just stupid then , is rent each month on a BTL the same ?


The same as what?


----------



## Duke of Marmalade (27 Jun 2017)

I am not sure I would answer False to (A).  Take the dot.com bubble.  Those stocks were quite the opposite of dividend paying. They were a punt on huge future growth.  If they had dividend paying capacity they wouldn't have crashed so spectacularly.

But as a believer in the EMH I hold that all shares are priced fairly - at least in the sense that I haven't a clue how to pick the bargains and I suspect very few people do have a clue; those that have picked the bargains probably just lucky.  Instinctively I believe that a dividend paying stock is less risky than a purely growth stock but, of course, the counter is that it has less upside potential.

Anyway the debate is only relevant in a pension fund context as a tax paying investor should seek to avoid dividend paying stocks.


----------



## galway_blow_in (27 Jun 2017)

Sarenco said:


> The same as what?



is the principal of receiving an income from investment property by way of monthly rent not the same as a dividend when it comes to stocks ? ( useless )

in the case of property , is capital appreciation the only goal in town ?


----------



## Sarenco (27 Jun 2017)

Duke of Marmalade said:


> I am not sure I would answer False to (A).  Take the dot.com bubble.  Those stocks were quite the opposite of dividend paying. They were a punt on huge future growth.


That's true Duke but I think you might be guilty of confusing correlation with causation.  

Berkshire Hathaway never pays dividends but I'm sure you wouldn't consider that to be a high risk stock - it certainly sailed through the aftermath of the dot.com crash.

The tax treatment of different sources of stock returns is also relevant to pension vehicles - don't forget dividend withholding taxes.


----------



## fistophobia (27 Jun 2017)

Sarenco,

I can show you a graph of global dividend index Vs. Euro Stoxx 50 over 5 years. It outperforms the latter, without factoring in dividends.


----------



## Sarenco (27 Jun 2017)

galway_blow_in said:


> is the principal of receiving an income from investment property by way of monthly rent not the same as a dividend when it comes to stocks ? ( useless )



Well rent and dividends are obviously both sources of income but the former is a legally enforceable promise (and in that sense is bond-like) whereas the later is simply an expectation.

Again, I didn't (and the article didn't) suggest that dividends (or rent for that matter) are a "useless" source of return.  The point is that there is no logical reason to prefer one source of return (income) over another (capital growth).

I've often made the point on here that over the very long-term the expected real capital growth of real estate is effectively zero.  It's the (net, after-tax) rental yield that really matters.


----------



## Sarenco (27 Jun 2017)

fistophobia said:


> I can show you a graph of global dividend index Vs. Euro Stoxx 50 over 5 years. It outperforms the latter, without factoring in dividends.


Five years is a meaninglessly short time frame in terms of stock market returns.  Also, why would you compare one (relatively concentrated) regional index with a global index in trying to prove anything?

In any event, the long-term outperformance of value stocks (and the correlation between dividend stocks and value stocks) is dealt with in the article.


----------



## galway_blow_in (27 Jun 2017)

read the irish times article again , i still dont get it

he claims the owner of the stocks might as well have just sold three of his stocks for three euro instead of taking the 3 euro cash payment , to me thats like saying you might as well sell the front and back door of your house for the same price as a years rent 

so what if the stock drops for the period of dividend execution , its an entirely temporary situation , you still maintain your stock holding , even you owned a stock which paid no dividend , it would very often drop by several percent countless times during the year , provided you dont sell  , what difference does it make ?


----------



## cremeegg (27 Jun 2017)

Sorry but I think it is an appalling article. Someone who knows a little sneering at those who know less.



Sarenco said:


> _
> Do you? To test, state if the following statements are true or false:
> 
> (A) Dividend-paying stocks are less risky than non-payers;_



Dividend paying stocks crystallise a partial return every 6 months. The Investor no longer has the full investment exposed to the market. This reduces risk.

Dividend paying stocks *tend* to be in mature stable industries. Utilities, not tech punts.
_


Sarenco said:



			(B) Like bonds, they offer free annual income as well as the potential for capital growth;
		
Click to expand...

_
What on earth does "free income" mean. Do bonds offer "free income" ? No you paid for it in the purchase price.

Obviously the dividend paid out is not available for reinvestment in the business.
_
(C) Dividend stocks are an especially good investment when bond yields are low, like today.
_
This is probably a reasonable assumption. With cheap money available high risk, high potential stocks are well supported. If interest rates rise such stocks will suffer far more than the boring dividend paying stock.

_


Sarenco said:



			Consider a company whose shares are priced at €1. It decides to pay its investors a 3 per cent dividend annually. On the date the dividend is due, the company will distribute €3 to a shareholder with 100 shares and the share price will drop by the amount of the dividend paid, to €0.97. What’s the difference between this and a non-dividend paying company whose share price remains at €1 throughout?
		
Click to expand...

_
This is just a statement of the blindingly obvious.
_
_


----------



## Sarenco (27 Jun 2017)

galway_blow_in said:


> read the irish times article again , i still dont get it


Here's a link to a video that might help.
http://review.chicagobooth.edu/finance/2017/video/free-dividend-fallacy-could-be-costing-you


----------



## Duke of Marmalade (27 Jun 2017)

I think we must take the article as being addressed at the layman who after all hasn't a clue about these things. I think it's a bit condescending for us know alls on AAM to lambast it.  The general thrust that, contrary to intuitive first thoughts, one shouldn't seek out high dividend stocks is valid.


----------



## Sarenco (27 Jun 2017)

cremeegg said:


> This is just a statement of the blindingly obvious.


I would have thought so but a lot of people don't seem to grasp the point - often to their detriment.  

Incidentally, I don't think it's just investing novices that fail to understand the issue.


----------



## galway_blow_in (27 Jun 2017)

Duke of Marmalade said:


> I think we must take the article as being addressed at the layman who after all hasn't a clue about these things. I think it's a bit condescending for us know alls on AAM to lambast it.  The general thrust that, contrary to intuitive first thoughts, one shouldn't seek out high dividend stocks is valid.



thats a fair point but an entirely seperate one to the one made in the article , take energy stocks right now, due to low oil prices , many energy stocks dividend yields have climbed remarkably high , this might seem like a huge plus but the yields are high because the stock price has dropped , a wall st guy named kevin o leary claims any stock with a dividend yield of over 3.5% smells funny to him

the author in the article dismisses dividends full stop


----------



## galway_blow_in (27 Jun 2017)

Sarenco said:


> I would have thought so but a lot of people don't seem to grasp the point - often to their detriment.
> 
> Incidentally, I don't think it's just investing novices that fail to understand the issue.



i still dont understand it , i must be stupid , i have only a relatively small amount of money tied up in stocks but my choice is either a vanilla index fund or high ( 5% plus ) dividend yield stocks for the long term as i dont know enough to pick winners in the growth sector , my attitude is over a ten year period , most index funds will at best average 10% per anum total return , if my dividend stock is paying me 7% , i dont need that much capital appreciation over the decade to match said index

during bear markets , i still get the high dividend from the likes of the energy stocks where as the index fund is only paying around 2.5% while its capital value is down 20%


----------



## Sarenco (27 Jun 2017)

galway_blow_in said:


> the author if the article dismisses dividends full stop


No, he didn't!


----------



## Jim2007 (27 Jun 2017)

Sarenco said:


> If your cash rich companies simply bought back your stock you would be in the same economic position.



But this is not the same thing as partially disposing of a position in order to obtain income!  In a buy back you still retain a right to share in the same benefits of the company going forward.  In disposing of the shares you reduce your right to future benefits.  The suggesting being made is, as with all M&M related theories, all things being equal it works.  But in the real all things are never equal.


----------



## Sarenco (27 Jun 2017)

Sorry Jim but I'm struggling to understand your point. 

If you are saying that receiving a dividend payment on a stock and failing to reinvest same in the same stock is the financial equivalent of selling stock then we are in violent agreement.  However, I suspect you are making a more subtle point that unfortunately is eluding me.


----------



## Duke of Marmalade (28 Jun 2017)

I know from their past contributions that the posters on this thread know their onions so the fact there is such disagreement on a very simple matter must be down to misinterpretations. Let me try and clarify.

First of all I am sure we can all agree that apart from tax considerations share buy backs have the same economic effect as dividends.  The dividend policy of a company says a lot about its position in its development cycle and so IMHO is relevant.  The analogy with Real Estate is I think helpful.  Consider three different RE propositions.

1)  A development site.  There are no "dividends" here.  Nonetheless it has value, mainly derived from its future potential to pay dividends/rent.

2)  A long leasehold or freehold rented out.  Clearly there is a capacity for a steady income payment.  A modest rental yield will apply.

3) A leasehold nearing expiry.  Rental yields can be expected to be very high in this situation.

So a start up high tech company will be similar to (1).  A longstanding utility will be similar to (2) and an insurance company closed to new business will be similar to (3).  

So what point am I making?  Presuming all else equal the dividend policy of a company says a lot about its place in the development cycle.  And on a spectrum we would go from high risk/high potential in (1) above through low risk/lower potential in (2) to safe/boring in (3).

I am not quite sure what point the IT article is making but if it is simply that dividends do not derive from Scotch mist then it is addressing an audience who in terms of financial awareness would have to be described as special needs.  (_Sarenco _BH is a beast of an entirely different colour.)


----------



## Sarenco (28 Jun 2017)

The article is simply making the point that many investors act as if dividends and capital gains are separate disconnected attributes of the total return on a stock, not fully appreciating that dividends come at the expense of price decreases and making this mistake has various consequences.

The reality that the price of a stock falls to offset a dividend payment might seem incredibly obvious to some posters but I think this thread adequately demonstrates that others struggle to get beyond the simple idea that harvesting fruit from a tree is different to harvesting the tree itself.

On the point regarding the relative riskiness (volatility) of high yield stocks versus the broader market, I would note that over the last 10 years the annualised standardised deviation and maximum drawdown of the MSCI World High Dividend Index was actually higher than the broader MSCI World Index.  The gross total return of the broader index was also higher over the same period (and that obviously ignores real world reinvestment costs and, more importantly, taxes).


----------



## Monksfield (28 Jun 2017)

The major plus as regards companies which continuously pay meaty dividends is that it imposes a huge discipline on management. Generally prevents them from making stupid acquisitions and encourages them to deploy capital sensibly. I would bet that companies which are committed to paying and growing above average dividends are less inclined to engage in aggressive accounting.


----------



## Duke of Marmalade (28 Jun 2017)

Sarenco said:


> The article is simply making the point that many investors act as if dividends and capital gains are separate disconnected attributes of the total return on a stock, not fully appreciating that dividends come at the expense of price decreases and making this mistake has various consequences.
> 
> The reality that the price of a stock falls to offset a dividend payment might seem incredibly obvious to some posters but I think this thread adequately demonstrates that others struggle to get beyond the simple idea that harvesting fruit from a tree is different to harvesting the tree itself.
> 
> On the point regarding the relative riskiness (volatility) of high yield stocks versus the broader market, I would note that over the last 10 years the annualised standardised deviation and maximum drawdown of the MSCI World High Dividend Index was actually higher than the broader MSCI World Index.  The gross total return of the broader index was also higher over the same period (and that obviously ignores real world reinvestment costs and, more importantly, taxes).


I suppose I missed the main category of high dividend stocks. Continuing the analogy with RE we have category (4) a tenant is about to leave and there is considerable uncertainty over the re-let.  Rental yield will be high to reflect the uncertain prospects.  I suppose most high dividend stocks are reflective of doubts over their future and therefore by definition are high risk.  The moral is that one needs to understand the reason for the high dividend yield (or more correctly why  the share price is low compared to the dividend).  The Phoenix insurance company has a high dividend yield but that is because it is in wind down and actually its future cashflow is fairly predictable.  I presume it is more usual for the dividend yield to be high for the exact opposite reason viz. future cashflow is uncertain.


----------



## galway_blow_in (28 Jun 2017)

Sarenco said:


> The article is simply making the point that many investors act as if dividends and capital gains are separate disconnected attributes of the total return on a stock, not fully appreciating that dividends come at the expense of price decreases and making this mistake has various consequences.
> 
> The reality that the price of a stock falls to offset a dividend payment might seem incredibly obvious to some posters but I think this thread adequately demonstrates that others struggle to get beyond the simple idea that harvesting fruit from a tree is different to harvesting the tree itself.
> 
> On the point regarding the relative riskiness (volatility) of high yield stocks versus the broader market, I would note that over the last 10 years the annualised standardised deviation and maximum drawdown of the MSCI World High Dividend Index was actually higher than the broader MSCI World Index.  The gross total return of the broader index was also higher over the same period (and that obviously ignores real world reinvestment costs and, more importantly, taxes).



dividend pay out ( or execution ) just happens to coincide with a share price decrease , the share can bounce back to where it was prior to the dividend ex date within a week in some cases , there are plenty of examples of  solid dividend paying stocks which have outperformed stocks which dont pay any at all 

again , so what if the share price temporarily falls to facilitate a dividend pay out ?


----------



## Sarenco (28 Jun 2017)

No, a dividend payment causes a share price decrease.  That's really the key point that you don't seem to understand.


----------



## Jim2007 (28 Jun 2017)

galway_blow_in said:


> dividend pay out ( or execution ) just happens to coincide with a share price decrease



If that were the case, then it would just happen with amazing consistency!  No at least part of the drop when the stock goes ex-div is accounted for by the fact that it has gone ex-div.  Just of apart of the uptake again is accounted for by the fact that the share has again started to carry a dividend right.


----------



## galway_blow_in (28 Jun 2017)

earlier poster could well be right , question of interpretation , a dividend cash pay out reduces the value of a company ( on ex dividend date )  so this ( at best ) slows the pace at which the stock price would - should otherwise  appreciate

my point is due to bear markets where stocks will fall no matter what , at least you get the cash pay out every quarter from a dividend payer , im not sure im comfortable being only focussed on capital growth as you cant live off it


----------



## Sarenco (28 Jun 2017)

galway_blow_in said:


> a dividend cash pay out reduces the value of a company


And that reduction in value is reflected in the company's share price!

The reduction in the share price is offset by the corresponding dividend payment - and vice versa.  Leaving taxes and costs aside, there is no rational reason to prefer one over the other.  Your stated preference is entirely behavioural.


----------



## fistophobia (28 Jun 2017)

There are people who like dividend paying companies, and I am one of them.

Some investors like or need regular income, without having to trigger CGT, or trading costs.
Dont invest in dividend paying companies - that is like saying, I dont want a pay rise, because I will have to pay tax on it.

Agreeing with one of the above posters, a company with a progressive dividend policy is a strong company.

There are companies such as these, and you can buy them as one basket.
It does not matter if the share price goes down XD, by whatever the div. amount is. We all know this.
If you are investing for income - the XD adjustment does not matter. I am looking at intra-day price moves on XD date, say 0.5%.
They mean nothing when the market is moving up and down intra-day.
I like Total Return (income and capital growth) - its the holy grail of investing.


----------



## Sarenco (28 Jun 2017)

fistophobia said:


> Dont invest in dividend paying companies


Did anybody say "don't invest in dividend paying stocks"?  I certainly didn't.

I did, however, say that many investors had an irrational preference for dividends over capital gains as a source of return and you clearly fall within that bracket.

The usual reasons given are that stocks with high dividend yields are intrinsically less volatile or produce higher total returns over the longer term.  Neither of these statements are true on a stand-alone basis.

You seem to agree that a dividend payment is offset by a price decrease in the stock price and then go on to say that it doesn't matter.  Well it may not matter to you - but it should.

Of course stock values change constantly in response to the absorption of new information by the market.  The fact that this might disguise or mask the fact that a dividend payment is offset by a corresponding decrease in the relevant stock price doesn't mean it isn't happening.  The market obviously has no responsibility to deliver what you "like or need".

You seem to be arguing that dividends are treated more favourably from a tax perspective than capital gains.  That is pretty clearly not the case in almost all cases so I may have misunderstood your point in this regard.



fistophobia said:


> I like Total Return (income and capital growth) - its the holy grail of investing.


Total return is what you get regardless of your (irrational) preferences - it's certainly not a "holy grail".

Incidentally, I assume you understand that "total return" implies that you immediately reinvest all dividends received?


----------

