The Irrelevance of Dividend Irrelevance

I recently had someone unsubscribe from this blog. That person was kind enough to let me know why – it was because I often endorse dividend growth investing.

This former-reader pointed to a behavioural bias called ‘mental accounting’ to demonstrate what they believe to be the flaw in dividend growth investing. Instead of separating returns into two forms – dividends + capital growth – this person argued that investors should focus on total returns. Moreover, by focusing on companies that pay growing dividends I am ignoring a large part of the market (e.g. the Teslas, Snowflakes of the world).

The funny thing is I actually agree with this person.

The ability to capture returns on a consistent, frequent basis helps many investors stay the course over the long run.

However, unlike the reader I believe that this behavioural ‘flaw’ is what helps dividend investors become BETTER long run investors.

The first thing people need to understand is investing is about what you take home at the end of the day. It’s about your personal returns on your account, relative to the risk you’re willing to take.

Most people start out believing they are ‘growth’ investors. That is, until they run into a bear market. Suddenly, they become ‘conservative’. People are allowed to change their minds. The problem is that these shifts create destructive financial behaviours.

In theory, the simplest, most efficient portfolio strategy might be to buy and hold a low-cost S&P 500 ETF. The problem is reality is messy.

In reality, the average investor dramatically underperforms the buy-and-hold S&P 500 portfolio over the long run. Why? Because they trade too frequently. They get excited after stock prices have run up (and buy) and then get scared after stocks have fallen (and sell). And then they sit in cash as the market rises again. Most investors buy HIGH and sell LOW.

I believe that dividend investing helps mitigate emotional trading. It is precisely because dividend investors separate their total returns into dividends + capital gains that keeps them from buying and selling on emotion.

I believe that dividend investing helps mitigate emotional trading.

Whether the markets are up or down, dividends still get paid. It is much easier to hang on to an investment if the positive reinforcement of dividends rewards you for doing so. Some refer to this phenomenon as ‘getting paid to wait’. In contrast, investors holding non-dividend paying stocks don’t receive that positive reinforcement.

The bottom line is that two similar investments might have the same expected total returns, but the characteristics of those returns have a significant impact on investor behaviour. The ability to capture returns on a consistent, frequent basis helps many investors stay the course over the long run.

Of course, this doesn’t apply to 100% of investors. Some investors will have better control over their emotions and have the intestinal fortitude to ride the big waves. It is entirely possible these investors beat the market over the long run. However, the empirical evidence suggests most investors are not in this category and require behaviour management.

Dividend Policy is Irrelevant? Yes and No.

Does this mean all companies should pay dividends? Definitely not. Dividend and stock buyback policy depends on the opportunities faced by the company.

Some argue that dividend policy is irrelevant to investors (because they can create ‘home made’ dividends by selling shares) and to the valuation of a firm (because they can raise capital if needed). This is technically true…in theory.

However, like all academic theories it comes with a lot of assumptions. A big one is that corporations have a better use for cash than their shareholders, and by paying dividends the company would be forced to raise debt or equity capital. This is why a company like Tesla doesn’t pay a dividend. The company believes it can earn a better return on invested capital than its shareholders. Clearly, this alone doesn’t make Tesla a good or bad investment.

Now, if Tesla couldn’t earn a high return on capital and still chose not to return cash to shareholders, you would have to question its motives. Many corporations hoard cash to build empires for their executives. A bigger empire = more executive pay. But it doesn’t necessarily mean greater shareholder returns.

Well managed mature companies return excess cash to shareholders. Well managed growth companies do not.

Over the long run every company eventually matures and must return cash to shareholders. For this reason, one might say that over the long run dividends are the ONLY thing that matter.

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