My Worst Investment Ever Podcast

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


Listen Later

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.

 

“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

 

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 Stocks

In 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 dividend

As 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 matter

Larry 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 theory

The 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 reading
  1. Merton Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of Business (October 1961).
  2. 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 Outperform
  • Enrich Your Future 01: The Determinants of the Risk and Return of Stocks and Bonds
  • Enrich Your Future 02: How Markets Set Prices
  • Enrich Your Future 03: Persistence of Performance: Athletes Versus Investment Managers
  • Enrich Your Future 04: Why Is Persistent Outperformance So Hard to Find?
  • Enrich Your Future 05: Great Companies Do Not Make High-Return Investments
  • Enrich Your Future 06: Market Efficiency and the Case of Pete Rose
  • Enrich Your Future 07: The Value of Security Analysis
  • Enrich Your Future 08: High Economic Growth Doesn’t Always Mean High Stock Market Return
  • Enrich Your Future 09: The Fed Model and the Money Illusion

Part II: Strategic Portfolio Decisions
  • Enrich Your Future 10: You Won’t Beat the Market Even the Best Funds Don’t
  • Enrich Your Future 11: Long-Term Outperformance Is Not Always Evidence of Skill
  • Enrich Your Future 12: When Confronted With a Loser’s Game Do Not Play
  • Enrich Your Future 13: Past Performance Is Not a Predictor of Future Performance
  • Enrich Your Future 14: Stocks Are Risky No Matter How Long the Horizon
  • Enrich Your Future 15: Individual Stocks Are Riskier Than You Believe
  • Enrich Your Future 16: The Estimated Return Is Not Inevitable
  • Enrich Your Future 17: Take a Portfolio Approach to Your Investments
  • Enrich Your Future 18: Build a Portfolio That Can Withstand the Black Swans
  • Enrich Your Future 19: The Gold Illusion: Why Investing in Gold May Not Be Safe
  • Enrich Your Future 20: Passive Investing Is the Key to Prudent Wealth Management

Part III: Behavioral Finance: We Have Met the Enemy and He Is Us
  • Enrich Your Future 21: Think You Can Beat the Market? Think Again
  • Enrich Your Future 22: Some Risks Are Not Worth Taking
  • Enrich Your Future 23: Seeing Through the Frame: Making Better Investment Decisions
  • Enrich Your Future 24: Why Smart People Do Dumb Things
  • Enrich Your Future 25: Stock Crashes Happen—Be Prepared
  • Enrich Your Future 26: Should You Invest Now or Spread It Out?
  • Enrich Your Future 27: Pascal’s Wager: Betting on Consequences Over Probabilities
  • Enrich Your Future 28 & 29: How to Outsmart Your Investing Biases

About Larry Swedroe

Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.

 

[spp-transcript]

 

Connect with Larry Swedroe
  • LinkedIn
  • X
  • Website
  • Books

Andrew’s books
  • How to Start Building Your Wealth Investing in the Stock Market
  • My Worst Investment Ever
  • 9 Valuation Mistakes and How to Avoid Them
  • Transform Your Business with Dr.Deming’s 14 Points

Andrew’s online programs
  • Valuation Master Class
  • The Become a Better Investor Community
  • How to Start Building Your Wealth Investing in the Stock Market
  • Finance Made Ridiculously Simple
  • FVMR Investing: Quantamental Investing Across the World
  • Become a Great Presenter and Increase Your Influence
  • Transform Your Business with Dr. Deming’s 14 Points
  • Achieve Your Goals

Connect with Andrew Stotz:
  • astotz.com
  • LinkedIn
  • Facebook
  • Instagram
  • Threads
  • X
  • YouTube
  • My Worst Investment Ever Podcast

...more
View all episodesView all episodes
Download on the App Store

My Worst Investment Ever PodcastBy Andrew Stotz

  • 4.9
  • 4.9
  • 4.9
  • 4.9
  • 4.9

4.9

61 ratings


More shows like My Worst Investment Ever Podcast

View all
Masters in Business by Bloomberg

Masters in Business

2,171 Listeners

Top Traders Unplugged by Niels Kaastrup-Larsen

Top Traders Unplugged

574 Listeners

Money Tree Investing by Money Tree Investing Podcast

Money Tree Investing

647 Listeners

We Study Billionaires - The Investor’s Podcast Network by The Investor's Podcast Network

We Study Billionaires - The Investor’s Podcast Network

3,366 Listeners

The Meb Faber Show - Better Investing by The Idea Farm

The Meb Faber Show - Better Investing

929 Listeners

Animal Spirits Podcast by The Compound

Animal Spirits Podcast

2,003 Listeners

The Rational Reminder Podcast by Benjamin Felix, Cameron Passmore, Mark McGrath, and Dan Bortolotti

The Rational Reminder Podcast

425 Listeners

Bogleheads On Investing Podcast by bogleheads

Bogleheads On Investing Podcast

573 Listeners

The Compound and Friends by The Compound

The Compound and Friends

2,046 Listeners

The Long View by Morningstar

The Long View

850 Listeners

Sound Investing by Paul Merriman

Sound Investing

325 Listeners

Excess Returns by Excess Returns

Excess Returns

69 Listeners

The Long Term Investor by Peter Lazaroff

The Long Term Investor

125 Listeners

The Great Retirement Debate with Ed Slott & Jeffrey Levine by The Great Retirement Debate with Ed Slott & Jeffrey Levine

The Great Retirement Debate with Ed Slott & Jeffrey Levine

121 Listeners

The Morgan Housel Podcast by Morgan Housel

The Morgan Housel Podcast

999 Listeners