Chasing Dividends? You’re Doing it Wrong!
Are you a dividend-chaser?
In their 1961 paper, “Dividend Policy, Growth, and the Valuation of Shares,” Merton Miller and Franco Modigliani established that dividend policy is irrelevant to stock returns. A dollar in the form of a cash dividend and a dollar in the form of selling shares is equal (without considering variables like trading costs and taxes). And this theorem has not been challenged since, in academia.
If a company pays out $1 in the form of a cash dividend, it causes the stock price to drop by $1 (so it’s an equal offset).
Dividend-chasers tend to think that a dividend is a free lunch. That, somehow, because you still keep the share of the stock, the dividend was an extra bonus.
Said in another way, dividend-favoring investors create a separate “mental account” for dividends.
But mathematically-speaking, taxable investors should favor a self-created dividend, through the selling of shares to create their own cash flow. Because with dividends, you pay taxes on the whole amount that’s distributed, whereas on a self-created dividend you only pay taxes on the capital gains of the shares you sell. So you pay effectively less tax with a self-created dividend.
Larry Swedroe (Director of Research for Buckingham Strategic Wealth and prior Vice Chairman of Prudential Home Mortgage), mentions in his article “Investor’s Odd Affection for Dividends“:
“Hersh Shefrin and Meir Statman, two leaders in the field of behavioral finance, attempted to explain the behavioral anomaly of a preference for cash dividends in their 1983 paper “Explaining Investor Preference for Cash Dividends.”…the first explanation is that in terms of their ability to control spending, investors may recognize they have problems with the inability to delay gratification. To address this problem, they adapt 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 has a desire 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…by purchasing shares that pay good dividends, most investors persuade themselves of their prudence, based on the expected income. They feel the gain potential is a super added benefit. Should the stock fall in value from their purchase level, they console themselves that the dividend provides a return on their cost.”
A dollar is a dollar. A preference for cash dividends over that of selling shares of equal dollar amount, is illogical from a mathematical standpoint and is explained by behavioral finance (why many investors have this preference). This is not my opinion; but something that is widely accepted in academia. The fact is, self-created dividends are superior to cash dividends from a tax perspective. In a tax-advantaged account, there is no difference between the two, so a “total return” approach is the most appropriate method of tracking your overall returns.
If a cash dividend helps you stick to your budget better, and helps you sleep better at night, then by all means keep doing what you’re doing. But from an optimal return standpoint, just know that you’re getting a lower return if you’re focusing on high dividend only stocks (you’re tilting towards value-oriented companies and away from growth oriented companies), it’ll lower your overall diversification; and from a tax standpoint, you will end up paying more taxes (in a taxable account).