There is a belief held by a surprising number of investors, and a non-trivial number of professionals, that dividends are essentially a bonus. A reward paid out by a company for the privilege of owning its stock. Money that appears, like an allowance, without any corresponding cost.
It is one of the most persistent and consequential misconceptions in personal finance.
A Picture Worth a Thousand Words
Meb Faber recently ran a survey with thousands of respondents asking a seemingly simple question:
A stock yields 5%. It’s trading at $100 and pays a $5 cash dividend. After the distribution, what does the investor have?
- Option A: A stock worth $95 and $5 in cash.
- Option B: A stock worth $100 and $5 in cash.
The correct answer is A. When a dividend is paid, the stock price adjusts down by exactly the amount of the distribution. The investor hasn’t gained anything, they’ve simply had their own money handed back to them in a different form.
Among Faber’s core audience of financially sophisticated readers, 90% of professionals and 80% of individuals answered correctly. Encouraging…until you zoom out to the broader population. Among a general audience, only 60% of professionals and a mere 25% of individuals got it right.
That means three out of four individual investors believe dividends are free money.
As Faber put it, “this explains everything from the irrational preference for dividends to predatory offerings focused on paying out magically high dividends to hopes and dreams of passive income.”
A Bird in Hand
There is a psychological dimension worth understanding here, because the preference for dividends isn’t entirely irrational. Human beings crave certainty.
Investors like dividends for the same reason a bird in hand is better than two in the bush. A dividend is cash in the account. It’s real and earned. Capital appreciation, by contrast, is just a number on a screen. It doesn’t feel like income until you sell, and selling requires a decision, one that many investors either avoid or agonize over.
Dividends solve that problem by forcing the issue. The cash arrives without action required. For investors who want to fund spending from their portfolio, this feels enormously satisfying.
The math is the math but a different set of actions creates a different set of feelings. Receiving a $5 dividend from a stock that subsequently goes from $100 to $95 is functionally identical to selling $5 worth of shares in a stock that stayed at $100. It’s the psychological component that weighs on investors.
Don’t Fall for the Label
The financial industry understands this psychology intimately, and has built an entire marketing apparatus around it.
Dividend Growth. Rising Dividends. High Dividend. Dividend Achievers. Dividend Aristocrats. The names are carefully chosen. They evoke stability, reward, and an almost rhythmic reliability. They suggest that something special is happening — that these companies are giving investors something extra.
I’ll let you in on a little secret: they are not.
What the labels are really selling is the feeling. The false sense of certainty. The satisfaction of watching cash arrive in an account without having to make a decision. That is a genuine psychological benefit, we don’t dismiss it, but it is worth being clear-eyed about what you are actually paying for when you seek it out.
Because the math does not change based on what the fund is called. A $5 dividend from a stock price of $100 is the same outcome as selling $5 of a stock that stayed at $100. The account balance is identical. The experience of receiving it is not, and that gap between the math and the experience is exactly where the marketing lives.
Understanding how dividends actually work is not a small thing. It is, as Faber’s survey suggests, a fundamental input in the arithmetic of investing. Before chasing yield, chasing income, or chasing a fund with an appealing name, remember: the money in a dividend was yours to begin with.
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CONSIDER
Legendary Professor Ken French lays out two simple statements summarizing his decades of research on financial markets:
“Most investors are overconfident about their ability to identify opportunities in the market. The result is often bad investment decisions.”
“It appears by the behavior of many investors…[that] investors are so overconfident in their ability to pick winners that they are willing to systematically lose.”
Great investing starts with understanding yourself.
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Let’s get after it this week!
Brooks
Brooks Palmer, CFP® is Head of Investments at Root where he helps identify, evaluate, and implement investment solutions tailored to clients’ needs. In Full-Court Press, he breaks down what’s happening in the markets—cutting through the noise and jargon—while connecting it to Root’s core investment tenets so you can make the most of your money and your life!
The examples provided are hypothetical and for illustrative purposes only. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results. The information presented should not be construed as investment advice or a recommendation to buy or sell any security or implement a particular strategy.
Advisory services are offered through Root Financial Partners, LLC, an SEC registered investment adviser.