Dividend Investing Is Not Rational

In my lifetime, I have lived through difficult financial stretches. Periods where I did not have enough income to cover the bills. This has left me with a fear of not having enough income. This anxiety remains to this day even though I have been saving a large surplus of my income for years. Having a reliable income is key to financial security. This has led many people to turn to dividend investing.

In this article, I’m going to explain why dividend investing is not rational. Dividend or income investing appeals to the many fears and biases of the human brain, which makes it incredibly appealing to many people.

Dividends feel like free money

Dividend investing is an investing strategy in which investors select individual stocks that pay a hefty dividend. The thinking goes that high dividend-paying stocks will allow the investor to collect a stream of passive income while never having to touch their principal.

That sounds pretty good, right? If you “never touch your principal,” you won’t have to worry about running out of money, and you can live off the passive income provided by the dividends. It sounds like a lovely story. However, it is only that, a story.

One of the most damaging biases that investors suffer from is “loss aversion.” We have a much more intense negative feeling from losing than we do from winning.

• When we sell shares in our portfolio, it feels like we are losing.
• When we receive dividends from our portfolio, it feels like free money.

Dividends are not free money

When a company pays a dividend, the value of the company is decreased by the amount of the dividend. If company “A” pays out $50 million in dividends to its shareholders, the value of the company has just decreased by $50 million. That is an inarguable fact (that many dividend investors will argue against).

If you hold shares in company “A,” you would be no better off if the company paid out $50 million in dividends or reinvested into the company. This was discussed in a 1961 paper by Meron Miller and Frank Modigliani. Miller and Modigliani referred to this as the “Dividend Irrelevance Theory.” If investors are not better or worse off by receiving dividends, a rational investor should not care whether companies issue dividends or not.

Total returns are all that matter to the rational investor. When I say total returns, I mean the increase in share prices plus dividends. As an index fund investor, if I needed cash, I could simply create my own dividend by selling a few shares.

I’ve just made the rational case why we shouldn’t care about dividends. I will now layout a few reasons why dividend investing harms total investment returns.

Dividends are not tax-efficient

If you are investing in a tax-sheltered retirement account, you should be indifferent whether or not you receive dividends.

If you are investing in a taxable account, dividends will trigger additional taxes and reduce your net investment returns. If an investor receives $10,000 in dividends, they need to pay tax on that $10,000. If the share price increases by $10,000 but no dividends are issued, no tax is payable.

Receiving dividends at times when you don’t need the income will lead to unnecessary tax bills.

If an investor is selling shares to create income, they can control when this tax is paid by choosing when they want to sell their shares. By waiting to sell their shares in a year where their income is low, either in retirement or in a year where they have lost their job, they will pay less tax than the dividend investor who receives dividends during their high-income years.

Loss of diversification

The number of stocks in the global market that pay dividends has been steadily declining for decades.

• In 1991, 71% of global stocks paid dividends
• By 2012, only 61% of global stocks paid dividends

Focusing exclusively on stocks that pay dividends means you are excluding 40% of the global stock market from your portfolio. Dividend investors are making an inherit bet that dividend investing stocks will outperform the market moving forward. There is no evidence to suggest this is the case.

A minimal number of stocks drive market returns. Only 4% of U.S stocks accounted for 100% of the gains in the U.S stock market since 1926. The only way to guarantee you had that 4% of stocks in your portfolio would be to invest in the entire market through low-cost index funds.

Final thoughts

Dividend investing makes many investors feel good. I’ll admit, it does feel nice to look in my investing account every quarter when dividends are paid out.

However, it’s important to remember that dividends are irrelevant. The only thing that matters to the rational investor is total returns. That is an increase in share prices plus dividends paid.

When we consider the tax inefficiency and loss of diversification that comes with focusing on dividend-paying stocks, we can come to only one conclusion- dividend investing is not rational.

I originally published this article in Making of a Millionaire

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