Yield-hungry investors fall for ‘free dividends fallacy’

Part of the attraction of dividend payments is more psychological than real

In May, Apple announced a 10.5 per cent increase in its dividend to $13.22 billion annually, making it the biggest annual dividend in the world. Photograph: Carlo Allegri/Reuters

Interest rates have been on the floor for years, prompting frustrated and yield-hungry investors to turn to dividend stocks. There’s a problem, however: research indicates many investors make costly errors because they don’t actually get how dividend investing works.

Do you? To test, state if the following statements are true or false:

(A) Dividend-paying stocks are less risky than non-payers;

(B) Like bonds, they offer free annual income as well as the potential for capital growth;


(C) Dividend stocks are an especially good investment when bond yields are low, like today.

Kudos to those who answered false. Those who didn’t may be guilty of what researchers call the “free dividends fallacy”. Consider a company whose shares are priced at €1. It decides to pay its investors a 3 per cent dividend annually. On the date the dividend is due, the company will distribute €3 to a shareholder with 100 shares and the share price will drop by the amount of the dividend paid, to €0.97. What’s the difference between this and a non-dividend paying company whose share price remains at €1 throughout?

To many academics, such examples highlight why dividend policy is something of an irrelevance. In the 1960s, a classic paper by Nobel-winning economists Merton Miller and Franco Modigliani argued a firm's dividend policy had no bearing on its valuation. Investors shouldn't care whether a company paid a dividend or not, they said.

If the above investor with 100 shares wanted income, he could simply sell three shares – in essence, create a home-made dividend. It should make no difference whether he receives €3 in the form of a dividend or by selling shares – in both cases he is left with €97 of shares and €3 of cash. Investors who prefer high-yielding dividend stocks do not tend to think this way, indicating they may not be grasping dividend payouts trigger an equivalent decline in the share price.

Experts habitually recommend investors focus on total returns. A shareholder who sees a company’s share price rise from €1 to €1.10 has earned a 10 per cent return. This is no different to an investor who sees a share price rise from €1 to €1.07 and who also pockets a €0.03 dividend.


The problem, say Prof Samuel Hartzmark from the University of Chicago and Prof David Solomon from the University of Southern California, is investors wrongly think of dividends as offering a bond-like income stream; they mistakenly view dividends as additional income, rather than seeing it as a shift of money from the share price to the dividend. The pair, authors of a recent study entitled The Dividend Disconnect, call this the "free dividends fallacy".

Several tests confirmed this misconception drives investor behaviour. It’s well known investors are prone to the disposition effect – the tendency to sell winners rather than losers. However, Hartzmark and Solomon found investors are far less likely to sell a stock if it has only gained once dividends are included. Perceptions of gains and losses are “largely driven by price changes”, regardless of whether the price had been affected by dividend payments.

They also found investors were less likely in general to sell dividend stocks, holding them for longer periods than non-dividend stocks. Dividend investors are often more focused on the “perceived attractiveness of the income stream”, and less likely to pay attention to the potential for capital gains. Investors should focus on total returns, but they don’t view dividends and capital gains as equally important contributors to returns; rather, they “focus on one variable or the other”.

Thirdly, they found demand for dividend stocks rises when interest rates fall, suggesting investors see them as offering reliable bond-like income streams.

This is unsurprising. Even “respectable financial media outlets” discuss dividends “as a source of income on its own, separate from the capital gains component and without an obvious trade-off in terms of price”. Similarly, demand for dividends tends to fall when recent stock returns have very high; then, the small stream of dividend payments can seem less attractive relative to the large capital gains, “even though both parts contribute to total returns”.

Ordinary investors and sophisticated institutional investors tend to consider dividends and capital gains in “separate mental accounts”, they conclude, suggesting investors have a very “naive evaluation of their portfolio performance”.


Thinking of dividends as free money has consequences. Funds tend to buy other stocks rather than reinvesting dividends into the stock from which it came. This results in price pressure and disproportionately large index gains on days when dividend payouts are particularly high.

For ordinary investors, opting for dividend stocks can have negative tax consequences, as tax must be paid on dividends received. The tax burden associated with dividends is one reason why many companies – particularly in the United States – are increasingly issuing share buybacks rather than dividend payments. Share buybacks indirectly return money to shareholders by increasing the share price, without triggering immediate tax payments.

Additionally, sticking to dividend stocks means you are reducing the size of your investing universe, resulting in less diversified portfolios.

A separate study, Juicing the Dividend Yield, shows fund managers exploit investors' naivety by artificially "juicing" the dividend yield. Juicing refers to a practice whereby funds buy dividend stocks just before they are due to be issued to investors. After the dividend is collected, the stock is sold.

Juicing is a costly business – it results in poorer performance as a result of increased taxes and higher trading costs. However, it does what fund managers want it to do – such funds attract increased investor inflows. The funds benefit at the expense of their investors, leading the authors to warn: “Investors who seek an income stream are better off creating it by selling fund shares than by investing in a fund that juices.”


Dividend investors might argue their approach can be very profitable, and they’re half right – a mountain of international research has found high-yielding stocks have traditionally outperformed. The counterargument, however, is this confuses correlation with causation. The stocks didn’t outperform because they issued dividends. Rather, stocks with high dividend yields have historically tended to be cheap, unloved companies. Their cheapness and profitability – not the fact they issued dividends – was key to their outperformance.

The problem is today, dividend stocks are no longer cheap. The hunt for yield in recent years has resulted in investors piling into dividend stocks, driving up their valuations and setting the scene for future underperformance.

Ironically, investors have it backwards: they should be buying dividend stocks when bond yields are high (when lack of demand means the stocks are more likely to be cheap) and avoiding them when bond yields are low (when the stocks are more likely to be expensive).

Many investors will have good reasons to invest in dividend stocks, but part of the attraction is more psychological than real. Investors are attached to the idea of an income stream, but they can create their own home-made dividends by selling shares at a time of their choosing. However, many investors don't like this idea. In one experiment conducted by behavioural finance expert Prof Meir Statman, investors were asked to consider using $600 received as dividends to buy a TV set, or to sell $600 worth of shares so they could buy the TV.

The scenarios are identical, but investors preferred to spend their dividend income rather than to sell the shares.

Investors make “puzzling statements” about dividends, conclude Hartzmark and Solomon, as if they are a “cost-free stream of income”. Being aware of the dividends bias may help, but how best to teach investors “remains an open and interesting question”.