CFA Institute Journal Review summarizes "The Dividend Disconnect," by Samuel M. Hartzmark and David H. Solomon, published in Journal of Finance, Vol. 74, No. 5 (October 2019).
Many investors trade as though dividends and capital gains are disconnected, not recognizing that dividends can cause price decreases. This is known as the “free dividends fallacy.” Investors often focus on price changes rather than total returns and rarely reinvest dividends. Analysts are too optimistic when forecasting prices of dividend-paying stocks. Demand for dividends is higher during periods of low interest rates or poor market performance.
What Is the Investment Issue?
Standard models in finance suggest that value-maximizing investors should treat all money equally, irrespective of source. Dividends should therefore be irrelevant to investors in a world free of taxes and transaction costs. However, even when such frictions exist, one would expect investors to maximize the value of their positions after costs. The authors demonstrate that investors track price changes and dividends separately, rather than viewing them together as part of total return, and fail to recognize that dividends can result in a lower price. This mistake is referred to as the “free dividends fallacy.”
How Did the Authors Conduct This Research?
The authors use price, return, dividend, and marketwide index information from CRSP. Short positions are excluded. Individual investor data from January 1991 to November 1996 are considered. The authors also use information (from Thomson Reuters) about mutual funds and institutional investors over the period 1980–2015. They calculate returns and percentage price changes using a stock’s closing price from the day before it is sold and the price at which it was originally purchased. To calculate returns, the authors assume no reinvestment and use the cumulative dividend received over a period. For positions purchased multiple times, they use a value-weighted average of the various prices to calculate returns.
The authors then conduct tests to determine whether investors expect dividends to lead to price decreases. They find a correlation of –0.50 between daily prices and dividend yields for individual stocks. Institutions and mutual funds exhibit less of a response when the prices of dividend-paying stocks change. For dividend-paying stocks, mutual funds demonstrate a 1.1% lower disposition effect. Institutions display a 0.7% lower disposition effect than non-dividend-paying positions.
What Are the Findings and Implications for Investors and Investment Professionals?
The authors find that price changes are considered a more important measure of stock performance than capital gain. Past price changes tend to influence trading more than past returns, and dividends are seemingly not always factored into performance evaluation. Moreover, dividend-seeking investors tend to pay less attention to price changes. The authors show that investors are less inclined to sell a stock that pays higher dividends. They also find that dividend reinvestment is low among institutional investors and mutual funds. The impact of this is that portfolio weights of dividend-paying stocks can decrease from the ex-dividend date. In addition, analysts fail to account well for the impact of dividends when making price forecasts.
The authors highlight that because dividends are considered separately, investors might pay more attention to dividends when interest rates are low. Demand for dividend-paying stocks tends to increase when interest rates are low as well as after a period of poor market performance. Investors display a tendency to finance consumption via dividends rather than via capital gains. The free dividends fallacy can also result in dividend-seeking investors all buying the same stocks at the same time, leading to overpricing. As a result, total return can be 2%–4% lower over the next year.
Portfolio managers, pension fund trustees, and investors in general will find the conclusions presented in this research useful.
“If investors do not accurately perceive the trade-off between dividends and price changes, dividend payments will seem like an unambiguously positive aspect of stocks. The fact that this confusion exists even in the financial press is consistent with the effects we document.”