Dividend Investing Part 1: Psychology

Dividend investing is one of those topics in personal finance and investing that elicits strong emotional responses from people. Why? Two big reasons. First, on social media, the internet, and in real life, there are people for whom dividend investing has become an integral part of their identity. They have invested time and effort in it, achieved a good outcome, and want to share their experience. On the other side are people who have succeeded using a more diversified portfolio management strategy. The passion and personal investment for strategies that have financially empowered you are understandable. I get it – I write this blog.

The second reason is that both sides of the dividend debate have valid points, and the right strategy for an individual depends on their psychology, tax situation, and preferences. This post is the first in a series that will examine each of those factors, and then pull them together. Today, I’ll start with my thoughts about some of the cognitive challenges and psychology surrounding dividend investing.

What is Dividend Investing?

The first thing to define for the discussion is what dividend investing is. Dividend investing is a strategy of selecting stocks, or using an ETF that selects stocks, that prioritizes companies that pay dividends. There are variations on that, such as selecting companies that have not only paid dividends but also increased the amount they pay out as dividends over time.

Those more narrowly focused strategies can have attractive-sounding names, such as “dividend aristocrats.” People want common dividends, but obviously not “dividend commoners or peasants”. Similarly, “dividend growers” sounds better than “dividend stagnators” or “dividend shrinkers”, especially when you consider dividends to be intrinsically good. Besides marketing, those features are also very important to the performance of dividend stocks.

The Irrelevance of Dividends

Calling dividends irrelevant is antithetical to dividend investing. Saying that, or even worse, making a video about the irrelevance of dividends, may cause meltdowns for those with #dividend in their social media handle, but it is true from a pre-tax total return perspective.

When you buy a stock, you are buying a share in a company’s value. That value is based on its current assets and its projected future cash flow. The future cash flow is uncertain, and the more uncertain it is, the less value it is assigned towards the current share price. It is priced with a discount, and those buying the stock at that discount make a profit if the future unfolds as expected or better. In an efficient market, all information regarding value and future cash flows is currently “priced in“. While many equate paying dividends to good future prospects, it does not predict that.

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Dividends = Choosing Income > Capital Appreciation

When a company has excess profits, it has three options. They may reinvest that money to grow the company. That reinvestment will hopefully increase future profits and share value. The currently known probability of that plan is already reflected in the current share price. When they do not have great growth prospects from reinvesting profits, a company may choose to pay the money directly to shareholders as a dividend instead. Alternatively, they may buy back shares, thereby increasing the price per share. Regardless, if the money is kept within the company, the current share price is unchanged. If the money is paid out as a dividend, the share price decreases by that amount.

This is intuitively obvious, but dividend-lovers will rail against it, saying that you do not see the stock price drop exactly by the dividend amount. It is true that if you look at a chart, you do not see an obvious dollar-for-dollar price drop when a dividend is paid. There are a few reasons for that. When a dividend is announced, investors anticipate the dividend and the price change. That affects expectations of future cash flow as money is paid out rather than reinvested in growing the company. Also, the fluctuations in price, minute-to-minute and day-to-day, as information changes the larger outlook for a company, create too much noise to see a small signal.

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Dividends Are Not Free Money

This bears repeating because the internet dialogue and more formal research has shown that this is a common misconception. Dividends are not free money that magically pays shareholders out of thin air. It is paid out of the value of a company. So, it merely shifts the amount of the total return towards income and away from capital gains. Dividends are neither good nor bad on their own. This is not new information. However, dividends also have other attributes and associations that influence their attractiveness to real-world investors. That makes dividends relevant.

Dividend Income Feels Good

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People Understand Income

While working, it can be very motivating to see your portfolio producing income. That tangible and relatable result allows you to easily see how your investing is building financial independence. One of the most important aspects of achieving investment success is to spend less than you earn and invest the excess. Missing time invested in the markets is one of the most expensive mistakes that we can make (6-10%/yr on average). Some people have no problems being motivated by seeing the total value of their portfolio grow, while others really get a kick out of seeing their dividends roll in and re-investing them.

Again, our focus on income is also strong during the retirement phase. Without a paycheck rolling in regularly, having dividends rolling in regularly feels comforting. You need non-work sources of cash flow (not necessarily “income”) in retirement to replace your working income, but regular income seems more familiar.

Alternatively, cash flow could also come through creating your own “dividends” from your portfolio. This is done by utilizing the interest and dividends, as well as selling some of your investments, to make up the difference. Using this approach versus a dividend-focused approach can have both benefits and drawbacks. It may offer more control for tax planning purposes, but it also requires some effort, and people may be reluctant to sell assets. That could lead to underspending.

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Easier To Spend

Many people struggle to switch from accumulating to selling investments during retirement. Even when they should. Dying with millions when you could have enjoyed that money by spending or giving more while alive is not a victory. While no one wants to run out of money, underspending also results in missed opportunities and regret. Underspending is a common problem for people whose retirement depends on personal investments rather than a defined benefit pension. This is one of the potential benefits of buying into a DB pension.

Having some money automatically removed from your portfolio by dividends may help with spending. There is evidence that people spend more freely from dividends than capital gains, even when taxes and transaction costs are accounted for.

Still, those who are dividend-focused may be afraid to spend more than their dividends and realize capital gains, citing things like killing the goose that lays the golden eggs. Yes, overspending from your portfolio to risk outliving your money is bad, but never selling almost guarantees the opposite problem. Those who create their own “dividends” by selling investments may eventually get used to it. At least I have. Alternatively, some financial advisory firms, like PWL Capital, will even do it for you. That, coupled with financial projections, can help you spend with confidence and adjust as needed.

Do Dividends Make You Naughty or Nice?

There are interesting arguments on both sides of the dividend debate about their impact on investor behavior. Unfortunately, there is no good data about whether dividends make investors naughty or nice on average. That is okay. Each of us has a different psychological mix and react differently. No one is really “average”. Consider the arguments for and against dividends and how you may react and behave due to them.

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Increased Opportunity To Misbehave

Dividends are paid, and you then have to either reinvest them or spend them. If you reinvest them, you have to decide whether to buy more of the same stock or use that money to buy more of something else. On the one hand, the more often you look at and touch your portfolio, the more often you have to make decisions.

Each time we make a decision, we must overcome our human biases to avoid making behavioral errors. For example, buying what has recently gone up (recency bias or performance chasing). The opposite can also happen. For example, sitting on the cash (earning diddly-squat) due to some smart-sounding narrative of an impending market drawdown. Investors are famous for their expensive self-talk. Having to make decisions more frequently creates the opportunity to turn them into detrimental actions more often.

Automating as many tasks as possible helps to reduce temptations. You can sometimes automate dividend reinvestment using a dividend reinvestment program (DRIP), but that would systematically cause you to overconcentrate in whatever stocks pay the highest dividends.

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Getting Paid to Wait

One of the biggest challenges for investors is resisting the urge to sell during a bear market. Instead, holding on and waiting for the inevitable recovery. Or better yet, making the most of the correction or bear market.

One of the purported advantages of dividend investing is that it enables investors to remain patient. While stock prices can drastically fall during a market drawdown, dividends may still be paid as per usual. Seeing their investment paying them a dividend reminds them of the benefits of investing. Many equate that with being paid to wait.

If that would help you psychologically, then it is a plus in the dividend investing column. Companies will tend to smooth changes to their dividend policy during a crisis if they can see a path to rapid recovery. However, it is worth noting that in major bear markets, dividends are not immune. For example, during the 2008/9 global financial crisis, 43% of dividend payers reduced their dividends, and 14% eliminated them altogether. Canada was relatively spared in 2008/9 due in part to our stronger bank regulation. However, no one knows what the next major crisis will be. Being “paid to wait” sounds great. Just be prepared that you may not get paid as much as usual if it is a major bear market. Mental preparation helps prevent panic.

Dividend Sin: The Fatal Attraction

One of the common cognitive errors that humans make, particularly under duress, is an error of focus. Focusing in one on aspect, but missing the bigger picture. There is the potential for that with dividends. As we will unpack in later posts, dividends may be surrogate markers for some positive company attributes. Those have historically led to outperformance. However, too high of a dividend yield may be a warning sign.

Dividend cutters have the worst performance, and the market is forward looking. If the market intelligence senses trouble, price drops in advance. The lower current price with the historical dividend payments, boosts the current dividend yield. A dividend yield-focused investor may not see the danger until the dividend cut happens. Then, they have a lower dividend and a capital loss. So, you must be able to look for and see the big picture that includes those other attributes beyond dividend yield. That is easier said than done. It is called the dividend trap because the bait is alluring.

Even then, dividend investing, by its nature means less diversified investing and you are taking more company specific risk. There will be unexpected developments that you never saw coming. The higher a dividend yield you focus on, the narrower the field of companies that you are investing in. Specific risk is not a compensated risk. So, investing in enough different companies to mitigate it is important to get a more reliable positive outcome.

Dividend Psychology Is Relevant

Dividends impact investor psychology in important ways. While dividends are irrelevant to the pre-tax total return of a holding, they are very relevant in real life. On the psychological front, there is a lot of attraction. Dividend lovers really do love their dividends and will defend the strategy vigorously. It is easy to understand. People love income and it is a way to see their investments working for them.

During the accumulation stage, getting dividend income may help motivate some people to save and invest more. During a market downturn, some people find the income soothing. That may help them hold on to their investments. However, they should also be aware that dividends stocks are not immune and dividend cuts could occur. Psychologically damaging if that is your focus. In retirement, dividend income is easier to spend – a common challenge when savers should switch to spending.

Because dividends are paid out by a company rather than the company reinvesting the money, it introduces the need for the investor to make a decision. Each time we make decisions, there is an opportunity for us to fall prey to our biases. An awareness of those biases helps. So does automation. However, automation with DRIP is not optimal because it does not rebalance between stocks to keep specific risk in check. Focusing on high yields may increase risk due to less diversification. Plus, it may be bait for the dividend trap.

Dividends are also relevant for other reasons. One that is very relevant for Canadians is tax – whether for better and worse depends on the details. We’ll explore that in the next two posts.