Ben Felix over at Rational Reminder podcast spends some time in a recent episode explaining why dividends are less relevant whether we are pursuing wealth accumulation or financial independence income spending.
There are probably a fair bit of investors here who consider themselves dividend investors. My sensing is… despite what the research shows, there is a certain flawed bias that cannot be easily changed.
But I think it is good to consider what was discussed.
As a former dividend investor, hearing what was discussed in chat groups, and what prospects and clients asked, most of what was presented by Ben is on point.
The discussion starts near 42 min.
Here are the main points brought up.
Dividend Yield is Not a Unique Factor
Control studies of historical returns data across different markets, and asset classes show that certain factors explain the expected returns that you would get.
The research of Miller and Modigliani in 1961 and Fama & French in their famous 1993 paper show that dividend yield is not a unique factor.
The expected returns of a dividend portfolio can be explained by market beta, company size and relative price measure by book to market (i.e. investing in equity as opposed to risk-free fixed income, size and value). If we control the parameters well, dividends do not contain additional information about expected returns.
Those conscientious investors who do not believe in the work can go to Kenneth French’s website, download the high dividend data series and do the five-factor regression test.
Now, this does not mean that a portfolio of high dividend portfolio cannot beat the market over the long run. A high dividend portfolio should be able to.
What the research is saying is that the returns of the dividend portfolio are explained by factors such as value (low priced stocks) and robust profitability (operating earnings divided by book value).
The Free Money Concept Contributed to Making Dividend Investors Overpay for Dividends.
At the core of the theory of dividend, irrelevance is fungibility, that investors should treat money equally regardless of its source.
However, dividend investors do not treat dividends and capital gains as fungible.
Dividend investors criticize that the theory does not reflect reality and that the assumptions are too rigid (and other arguments).
Hartzmark and Solomon 2019 wrote the paper The Dividend Disconnect, which observed that investors view dividends as free money and account for them separately from capital gains.
This is what they refer to as the free dividends fallacy.
Dividend investors find a stock that pays a dividend to be more attractive than one that does not, so they have a preference for dividends.
They placed such a high value on the cash flow stream that they are willing to pay a premium for those cash flows above and beyond what a rational investor would.
If they pay higher prices, the future expected returns are lower.
Hartzmark and Solomon find that the demand for dividend stocks or high-income securities such as high yield bonds became higher when interest rates are low and bond interest payments provide less income.
Dividend seeking investors are likely to buy dividend stocks at the same time as one another.
The researchers estimate that investors buying dividend-paying stocks during times of high demand have reduced their expected returns by roughly 2 to 4% a year.
Daniel, Garlappi and Xiao’s 2021 paper Monetary Policy and Reaching for income also find that low-interest rates tend to lead to significantly higher demand for income-generating assets.
Dividend investors have a very strong “living off income” preference and this drives them to overpay for dividend yield.
The Lack of Diversification
In the US, the number of stocks that pay dividends as opposed to not paying is about 50/50.
Choosing to only invest in dividend stocks reduces your opportunity set.
Those companies that pay a consistent dividend tend to be larger, which means that you tend to miss out on the smaller company opportunity set.
The factor premiums, which explain part of the future expected returns, tend to be bigger in small caps and investors would benefit from the migration from small caps to large-cap and vice versa.
Ben examined the ProShares S&P 500 Dividend Aristocrats ETF (NOBL), which is a set of companies which have consistently paid rising dividends for 25 consecutive years. The ETF is overweight in basic materials, consumer defensive and industrials and underweight in technology.
An alternative to the NOBL is the Dimensional US High Profitability ETF, which will match NOBL in factor exposures but targets high profitability rather than high dividends but doesn’t tilt the sector weighting to such a large degree.
Thus, investing in the US High Profitability ETF allows you to be more sector-neutral.
Dividend Investing Tend to Be More Domestic
Taxes play a very important role in dividend investing.
In most countries, local citizens pay more favourable taxes on local dividends but incur higher taxes on direct or indirect dividends (in funds).
Dividend Investors Let The Dividend Frequency Dictate Their Spending Pattern
This is something that I do not get but the research shows that investors are very influenced by the frequency of dividend distribution.
Brauer, Hackethal and Hanspal in their 2022 paper Consuming Dividends analyze very detailed daily data from a German bank, which shows every tiny little bit of activity from both brokerage and bank accounts for the German clients of a particular financial institution.
Through the data, we can see the client’s whole financial life.
What they find is their private consumption is excessively sensitive to dividend income and that investors across wealth, income and age distributions increase spending precisely around the days of a dividend of receipt.
This suggests that people intentionally buy dividend stocks, anticipate income and plan for the consumption around dividends accordingly.
This is a problem because this is a rather arbitrary approach to determining the amount and timing of your spending. Total returns are harder to think about because they are not cash flows, and it does not automatically land in your bank account.
Dividends make it very appealing for mental accounting.
In financial planning, this is relatively easily resolved by determining how much can be sustainably spent from the portfolio and then spending that amount, regardless of the source of the returns.
If investors are interested in a variable spending strategy, which is what dividend investing is, they can accomplish this with a broadly diversified total return portfolio then spending the same amount adjusted for inflation each month.
They could just spend a percentage of their portfolio every year.
The downside of this method (and also the dividend investing method) is that the income becomes extremely volatile. If the portfolio drops 40%, your income will drop as well.
Some people do not want any variable in their income and they would have to adopt a spending system that is outside of dividend investing.
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