Many investors, especially those using a cash flow approach to spending, prefer cash dividends. From the perspective of classical financial theory, this behavior is an anomaly.
In their 1961 paper Dividend Policy, Growth, and the Valuation of Shares, Merton Miller and Franco Modigliani famously established that dividend policy should be irrelevant to stock returns.
As they explained it, at least before frictions like trading costs and taxes, investors should be indifferent to $1 in the form of a dividend (causing the stock price to drop by $1) and $1 received by selling shares. This must be true unless you believe that $1 isn’t worth $1. This theorem has not been challenged since.
Moreover, historical evidence supports this theory—stocks with the same exposure to common factors (such as size, value, momentum and profitability/quality) have the same returns whether or not they pay a dividend. Yet, many investors ignore this information and express a preference for dividend-paying stocks. The leading explanation for this preference is the “free dividends fallacy”—investors fail to realize that dividends are not free money but rather come directly at the expense of the stock price.
Despite the empirical evidence demonstrating that receiving a dividend should be irrelevant for investors, there is a large body of literature documenting that many investors treat dividends differently from other sources of payouts, leading to suboptimal performance. Could investors be educated to avoid the mistake of treating dividends differently? Andreas Hackethal, Tobin Hanspal, Samuel Hartzmark, and Konstantin Bräuer, authors of the May 2024 study Educating Investors about Dividends, sought to answer that question using an interactive quiz that educated investors on the economically appropriate financial intuition of thinking about dividends.
They began by noting that the “free dividend fallacy is likely rooted in ignorance, suggesting education can alleviate the bias. Such behavior is costly, as it typically leads to sub-par performance through a lack of reinvestment, higher taxes, and buying overpriced stocks when dividend demand is high.”
To try and help investors understand the fallacy and avoid these costs, in 2021, the authors partnered with a large German bank. “Germany is an ideal place for our intervention as German firms tend to pay one large dividend annually in the spring, making the payouts large and salient. In addition to allowing us to randomize investors into treatment groups, the bank provided data on trading behavior from before and after the treatment.” They added: “The current tax regime in Germany is such that investors should not have a preference for dividends over capital gains.”
They wanted subjects to understand that dividends came at the expense of the stock’s price. Thus, the investor should neither consume them nor treat them differently from share price appreciation. Participants were sent an email describing the basic logic of dividend irrelevance (when dividends are paid out, the firms’ share price normally decreases by the amount of the dividend) and an example using the DAX Index illustrating the large difference in performance with and without dividend reinvestment. The email explained that “investors attempting to achieve the performance of the total return index should be reinvesting rather than consuming dividend payouts.”
“Investors were asked to click on a link to learn more and take a survey in return for a 10 Euro gift card. The survey included further information and a brief interactive quiz to attempt to solidify the concepts and underscore these messages. Some investors were randomized into a zero-touch group and received no communications.” Their sampling procedure resulted in a zero-touch group of 8,327 investors, 6,637 investors who received a placebo treatment email and an invitation to a survey about dividends via an email with the same subject but did not explain the benefits of dividend reinvestment, and an over-sampled group of 21,023 investors who received the reinvestment email.
The first question presented to survey subjects was: “What generally happens to the price of a share just before the dividend is distributed to investors?” Investors could choose: a) The share price falls by approximately the amount of the dividend, b) Nothing, c) The share price increases slightly, or d) Not sure. “Regardless of whether the investor chose the correct (choice A) or incorrect option, they saw an intuitive explanation describing why the price decreases. It stated that If the dividend is still part of a firm’s balance sheet, it is reflected in the share price. When the dividend is paid out, it is transferred from the company to the investor and is consequently no longer included in the company’s share price. What does this mean for investors? Dividends are not ‘additional income’ because they come directly from the share price. After dividend payouts, investors are typically as rich as before.”
The second question gave the approximate level of the DAX index in March 2021 of 15,000 (which includes dividend reinvestment) and asked what level they think it would have been without dividend reinvestment. The correct answer is about 6,500 points.” The accompanying explanation concluded: “Anyone who has withdrawn and spent all dividends from DAX companies since 1988 only holds half as much in equity assets today.”
The third question asked whether an investor should care if cash came from dividends or from a share sale (a homemade dividend). “The attempt was to emphasize that if investors did not want to make a home-made dividend, they should want to reinvest a received dividend.” The explanation concluded: “If a partial sale is not desired, reinvestment should be made.”
After the three questions, they had a lessons learned section. The section stated, “To sum up: Dividends are not ‘additional income’ because they are directly deducted from the share price. If dividends are not reinvested, this is comparable to the partial sale of shares ... So if you want to benefit fully from the compounding and realize the full performance of a securities investment, you should reinvest dividends in securities.”
Here is a summary of their key findings:
Investor plans to reinvest some of their dividends increased by approximately 10 percentage points (statistically significant at the 1% confidence level) for those exposed to the reinvestment treatment message compared to the placebo treatment. Investors who received the reinvestment treatment, on average, increased the fraction of dividends they planned to reinvest by 8 percentage points relative to the mean pre-treatment stated reinvestment fraction of 38 percentage points.
Investors who were exposed to the reinvestment treatment were also 20 percentage points more likely to opt for a fund that automatically reinvests rather than distributes and 13 percentage points more likely to state that they would prefer that their dividends be automatically reinvested.
Investors with low quiz scores, “arguably those who got the most out of the information treatment,” increased their reinvestment purchasing by more than those who answered all quiz questions correctly. Further, investors who provided incorrect responses to the dividends quiz, who stated they learned something new or found the information informative, increased reinvestment behavior by a significantly larger amount than other participants.
The effectiveness of the “treatment” persisted over the following two years, with a positive effect on portfolio values— “while we cannot definitively rule out that consumption remained the same, the evidence is consistent with increased reinvestment and a lack of increasing consumption from other sources leading to increased savings.”
Their findings led the authors to conclude: “Our findings suggest the free dividends fallacy likely is an important driver of dividend demand…. Our finding suggests that some financial decisions can be improved with a targeted intervention.”
Given that dividends are tax disadvantaged in the U.S. for taxable investors (the full amount of the dividend is taxed, while only the gain resulting from a home-made dividend [by selling stock] is taxed), a behavioral demand for dividends results in even greater costs than it does in Germany.
Investor Takeaways
Advisors can help investors achieve better outcomes by helping them better understand the relationship between dividends and stock price changes. By doing so, investors will be able to characterize the gains from each appropriately and avoid some of the negative consequences that can result from this anomaly.
Larry Swedroe is the author of 18 books, the latest of which is Enrich Your Future: The Keys to Successful Investing.
