- Traditional economic theory tells us not to look at capital gains and dividends in isolation
- But new research says that spending dividends can be rational
There are many normal behaviours of which economists disapprove. Buying Christmas presents is one (unwanted gifts represent an efficiency loss); treating dividends as additional income is another.
In the 1960s, Nobel-prize-winning economists Merton Miller and Franco Modigliani published their ‘dividend irrelevance’ theory. In an efficient stock market, any dividend payout should see stock prices decline by the amount of that dividend. Holding a stock for the dividend, in theory, therefore achieves nothing: the stock price simply moves lower to adjust for the payout. Owning shares because of an attractive payout is frowned upon, too: investors can, after all, create a “homemade dividend” by selling stock as the need arises.
Economists argue that thinking about capital gains and dividend payments in isolation also makes little sense. Academics David Solomon and Samuel Hartzmark called this separation the “free dividend fallacy”, and warned investors against viewing dividends “as additional income, rather than a shift of money from the stock price to the dividend”.
Investors also know that reinvesting dividend income makes a huge difference to total returns. The table below shows that £100 invested in equities in 1899 would be worth just £152 in real terms without reinvested dividends. With reinvestment, it would have grown to £31,120. Dividends aren’t just a nice extra, they can turbocharge investment returns.
| Today's value of £100 invested at the end of 1899 | ||
|---|---|---|
Without reinvesting income (£) | ||
Nominal | Real | |
Equities | £16,838 | £152 |
Gilts | £48 | £0.43 |
Income reinvested gross (£) | ||
Equities | £3,450,736 | £31,120 |
Gilts | £34,361 | £310 |
Cash | £21,146 | £191 |
| Source: Barclays | ||
But as with Christmas presents, the economic theory seems to have little bearing on how people really behave. Research published this year by Paul Schultz, professor of finance at the University of Notre Dame, suggests that twice as many investors spend dividends than sell stock for living expenses. What's more, only 15 per cent of the 600 investors surveyed agreed that “spending dividends rather than reinvesting them will lead to a depletion of my assets”. Yet two-fifths agreed with the same statement when applied to selling shares. Are investors being irrational?
Perhaps not. Schultz argues that when companies commit to paying the same level of dividends over the future, they create an ‘implicit contract’ with shareholders. The dividend reassures investors that “you can consume at the level of the dividend for the foreseeable future without fear of running out of money”: valuable information for those who live off investment income. He adds that it is not the dividend per se that matters to investors, but the commitment to maintain a constant stream of dividends every quarter.
The working paper found that companies that broke their ‘implicit contract’ and cut dividends unsurprisingly suffered the consequences: for US-listed stocks, turnover over the year was higher by almost 11 per cent of outstanding shares. Schultz added that if a firm issues a dividend, it “needs to be able to commit to a level of payouts over the longer term”. Correspondingly, stock turnover dropped by 23 per cent after the company initiated a regular dividend.
He also notes that funding consumption from company dividends is easier than selling shares to generate income from ‘homemade dividends’. After all, investors don’t know how many shares to sell: if they release too many, they risk not being able to meet their future consumption needs. Crucially, through this lens, spending dividend income can be rational after all: by restricting consumption to just this income, inventors can ensure that they will be able to consume at the same level in the future. This, says Schultz, is why dividends matter.
