In my last post I argued there’s little reason to prefer investing in dividend stocks as compared to a more broadly diversified set of stocks that may or may not pay dividends.  While in some historical periods various baskets of dividend stocks have performed marginally better than a broader stock portfolio, dividends are not the cause of this slight out performance.  For example, portfolios focused on more direct measures of company value have generally out performed dividend portfolios.

It turns out that most of the reasons people cite for preferring dividend stocks are driven by emotions rather than a rational analysis of the facts.  If you find this conclusion debatable, I suggest you read my last post before proceeding on to the rest of this post.

What motivates many (perhaps most) investors to ignore the facts and prefer dividend stocks?  Much of Mindfully Investing is based on the apparent dichotomy between reason and emotion.  If people consistently do something irrational, some emotional need is likely being served.

Worry and Fear

The best explanation of the preference for dividend stocks has been around since at least 1984, when the behavioral economists Shefrin and Statman published a paper called Explaining Investor Preference for Cash Dividends.  It’s a fairly complicated technical paper, but fortunately, Larry Swedroe provides a good summary.  He notes three main reasons for investors preferring dividends, as proposed in the original 1984 paper:

1. Worry over a lack of self-control
2. Fear of investing losses
3. Fear of future regrets

I’ve taken some liberties and defined these three reasons using mindfulness terminology (worries and fears) instead of behavioral economics jargon (loss aversion and regret avoidance) used in the original Shefrin and Statman paper.  Let’s examine each one in turn.

Worry over Self-Control – Many dividend investors use their dividend portfolios in a specific way.  They spend some or all of the income generated from the dividends but rarely sell any shares of stocks.  As discussed in my last post, the “homemade” dividends approach of selling shares to generate income is mathematically identical to receiving dividend income.  There is no added value created by preferring one income method over the other.  So, the idea of spending only dividends is a convenience entirely of the investor’s own devising.

Shefrin and Statman postulate that spending only dividends is a self-imposed rule investors use to make sure they don’t overspend.  After all, if you use the homemade dividend approach, only your self-control prevents you from selling 20 shares instead of 10 shares and treating yourself to an extravagant night out.  But if you only spend dividends, a clear boundary is created.  And going beyond that boundary requires you to take action, log into your account, pay a small trading fee, and sell some shares.  It seems that investors hope these steps will make them pause and think about the prudence of spending that additional money.  In this view, a preference for dividends is a preference for automated self-control.

Fear of Losses – The “homemade” dividend approach creates the fear of losses in two potential ways.  One, selling shares to generate income may in some situations involve selling shares at a loss (at a price lower than the original purchase price).  Two, even if the shares are sold for a gain, the shares themselves are gone, never to return.  If you have a 100 shares and sell 10 at a profit, you only have 90 shares left at the end of the day.  This may feel like a loss.  Further, dividends support mental accounting that may help minimize feelings of loss generated by share price gyrations.   If your share price has declined, the dividends can be viewed as cash value that counteracts that loss.  As I noted in my last post, this is a pure fabrication, which ignores that share prices always decline by the amount of any dividend paid.  But such mental gymnastics may nonetheless reduce the sense of loss for some folks.

The fear of losses is a well-documented and powerful human motivator.  The behavioral economists Amos Tversky and Daniel Kahneman studied this fear and named it “loss aversion”.  They determined through experiments that, on average, people are willing to engage in a bet where the potential payoff is about twice or more than the potential loss.  They extrapolated from this behavior that people must hate losses about twice as much as they savor the feeling of a gain.*  These experiments also showed that exactly identical probabilities of gaining money were treated differently by test subjects, if the probabilities were expressed in terms of a potential loss as opposed to a potential gain.  For example, most subjects prefer a game of chance where they will likely win $50 to one where they would likely win $100 and then lose $50, even though the probability of netting $50 is exactly the same in both games.  For the same reason, “homemade” income suffers in a comparison to cash dividends.  With “homemade” income, it feels like something is lost (selling shares at a lower price or having fewer shares left after the transaction), while with dividend payments, it feels like something is gained.  Of course, the operative phrase here is “feels like”, because in reality, there’s no difference in the final total value of your account using either income method.

Fear of Regret – There’s an additional fear associated with selling shares to generate income.  Let’s use the same example again, where you sell 10 shares out of a 100 and end up with 90 shares after the transaction.  What if the next day the price of that stock sky-rockets by 50% due to some new product launch?  Most people will regret having sold the 10 shares the previous day, because they feel they missed out on some of the benefits of the sky-rocketing prices.  So, selling shares involves not only the present-day fear of losses but also the fear of potential bad feelings (regrets) in the future too.  In reality, the result is still the same in the sky-rocketing prices scenario whether using “homemade” income or dividends.  In the case of dividends, the value of the stock still declines by the amount of the dividend paid before it then goes on to sky-rocket by 50%.  So, with dividends, the total end value after the price action is still the same as if you had simply sold 10 out of your 100 shares.

Peace of Mind

I’ve written extensively about how mindfulness can help us deal with unproductive emotions like worry, fear, and greed while implementing our investing plans and our personal finances in general.  For investing, I’ve focused mainly on how mindfulness can minimize unproductive reactions like panic selling during a stock market crash.  But a mindful approach to investing can also help us formulate more rational investing plans in the first place.  The role of dividend stocks in our investments is a perfect example.  At first glance it’s easy to tell yourself that investing mostly in dividend stocks is a rational plan of action, at least because dividend portfolios have historically performed well.

Consider some of the major tenants of mindful investing, which I previously summarized in the Mindfully Investing Score Card:

• In most cases, don’t use financial advisers.
• Minimize investing costs where ever possible.
• True risk is not routine volatility, but the risk of permanent losses.
• Don’t try to time the market.  Buy and hold for the long term to avoid permanent losses.
• Don’t try to beat the market.  Market returns are sufficient to attain most reasonable investing goals.
• Prefer more “passive” index investing over more “active” investing.
• Use low-cost index funds instead of trying to pick individual stocks.
• Allocate heavily to stocks (as opposed to bonds and cash) in most situations.
• A moderate amount of stock diversification is prudent, but it can’t ensure a smooth ride or consistently better returns.
• Stocks are the best hedge against inflation.
• Reinvest any dividends consistently, but not too frequently, to boost long-term returns without adding too much in transaction costs.

A portfolio composed of low-cost stock ETFs based on dividend indexes would check most of these boxes.  Many such index funds are available including high dividend yield index funds, dividend appreciation index funds, dividend “aristocrat” index funds, dividend “select” index funds, etc.  And yet we’ve seen in the last two posts that there’s no compelling rationale for preferring a dividend index portfolio over an all-market portfolio composed of low-cost index ETFs that aren’t biased toward dividend payers.

Many dividend investors point to the peace of mind created by focusing on dividend stocks and receiving predictable dividend payments.  Avoiding worries and fears about potential losses undoubtedly contributes to that peace of mind.  However, a more mindful approach allows additional options with equal peace of mind.  I’ve written before about how over-diversification can lead us to feel our portfolios are more protected than they really are.  Nonetheless, limiting your investing universe to only dividend payers and growers necessarily narrows your stock portfolio, which may make it more vulnerable to certain types of market downturns.  For example, market downturns driven by rising interest rates often have a greater negative impact on dividend payers.

Fooling Ourselves

A key tenant of Mindfully Investing is the ease with which we can fool ourselves into thinking we are proceeding rationally when, in fact, we are still influenced by our emotions or innate cognitive biases.  One example I’ve written about in the past is the tragic story of “facilitated communication”.  Well meaning “facilitators” believed they were communicating on behalf of autistic children, but experiments showed the facilitators were only transmitting their own thoughts and wishes.  If such fundamental self-delusion is possible, imagine the extent to which we can delude ourselves about something relatively minor like the true reasons behind our preference for dividend stocks.

So, before you dismiss this post as the ramblings of crank who simply doesn’t understand all the thought and logic you’ve put into developing your dividend portfolio, stop and ask yourself a few questions.

• When and how did your preference for dividend stocks actually start?  I’ll bet you ran across the idea in a news article, or a friend or adviser suggested it.  And at the time, it struck you as a decent idea that might be worth pursuing.
• Since that first interest in dividend stocks, how much of your research and effort actually questioned the wisdom of dividend investing?  In contrast, how much of your efforts have been more about validating your original interest in dividend investing?
• As you read this, are you thinking mostly about ways to defend dividend investing or at least considering the merits of my arguments?

If you’ve already spent a lot of time and effort trying to knock over the straw man of dividend investing, then I’ll leave you alone.  You can proceed with your dividend portfolio without another complaint from me.  But if you’ve haven’t challenged your assumptions, then I suggest you give it a try, and see what happens.

A dividend focused portfolio is not entirely irrational by itself.  Dividend portfolios have been shown to perform well under a range of historical conditions, and this history suggests they could meet your investing goals.  The irrational part is thinking that dividends are the only good way to generate income from stocks, are the primary source of superior performance in any given period, or that dividends somehow magically convey stability to your portfolio that’s not available from other types of stock allocations.  Rather, dividends are just another example of how investors need to constantly guard against emotional preferences disguised as rational plans.

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*Note: I’ve always found this highly repeatable experiment somewhat puzzling in light of the entire gambling industry.  If we hate losses so much, why do so many people volunteer to lose money at casinos and other gambling venues, even though everyone knows the odds favor the house?  Personally, I hate gambling, because to me, it feels like setting money on fire.  But there are many many people who find gambling thrilling.  I suspect that dual motivations are at play here, where loss aversion is somehow counteracted by the potential thrill of the win under certain circumstances.  Perhaps this just shows that predictably applying any of these behavioral economics rules to a real-world setting is a very complex task indeed.