The dividend fallacy

[hiriskpaul]

Dividends are paid at the expense of capital growth. Capital growth occurs at the expense of dividends. Total return is the only true measure of the performance of a share, but you may prefer one or the other for tax reasons. Hardly a fallacy.

All true, the fallacy is in believing otherwise - that dividends are like interest payments. False assumptions based on the fallacy are not uncommon and are easy traps to fall into.

Ever come across statements such as "The share price has fallen, but that is OK provided the dividend is maintained"?

For another example, I was once sent a magazine by Hargreaves Lansdown discussing equity income funds and the article actually stated that share price falls were good as it meant the dividend payments bought more units when share prices were low. Utter nonsense of course, relying on the fallacy that dividend payments are equivalent to interest payments.

On the whole I agree but it is not theory it is fact. When a dividend is paid the assets of the company have fallen by that amount. You do not need any theory to confirm that fact. But that simply has a (usually modest) effect on the NAV per share, note the 'V' in NAV. It may or may not affect the share price which is altogether a different matter.

On JohnB's points, I prefer dividends to capital growth because of my circumstances and it has nothing to do with tax since most of my shares are held in an ISA or a SIPP but I agree that total return is the only true measure of the success or otherwise of a share. I agree that dividends are paid at the expense of capital growth most of the time. I am not so sure about capital growth being at the expense of dividends though. Reading that one would think that capital growth is a given. It is not.

Dod

When a share goes XD, the dividend per share comes off the share price. So if there is a 5p per share dividend, 5p comes out of the share price. However, the share price is of course affected by other things as well. What happened overnight in Asia, the futures market, RNS and other news items can all make MMs change a share price before the market opens. That can happen even when there is no specific news about a particular share, or even the sector and without a single trade taking place in the share. So although the dividend per share comes out of the price, it is very hard to actually see this. With something like the FTSE 100 ETF, there is a lot of news that moves the price overnight. For example, on 12 March 2020, ISF went XD with a 6.35p dividend, but the price dropped over 70p!

The only way to spot the XD price movements that are due to the dividend payments is to average over a large number of payments. That way much of the market noise is cancelled out as the affect on share prices due to short term news flow should average to zero.

Does that make more sense?

[OhNoNotimAgain]

It is worth considering whether the company paying the dividend could utilise the money itself better than the shareholder and the tax efficiency of either course.

And that decision changes over time.

For example would a gearbox or a fuel injection manufacturer serve its investors best by reinvesting in better products or paying a dividend to allow the investor to allocate that cash into a battery maker?

[hiriskpaul]

All true, the fallacy is in believing otherwise - that dividends are like interest payments. False assumptions based on the fallacy are not uncommon and are easy traps to fall into.

Ever come across statements such as "The share price has fallen, but that is OK provided the dividend is maintained"?

For another example, I was once sent a magazine by Hargreaves Lansdown discussing equity income funds and the article actually stated that share price falls were good as it meant the dividend payments bought more units when share prices were low. Utter nonsense of course, relying on the fallacy that dividend payments are equivalent to interest payments.

Hmm, maybe I'm naive, but aren't dividends rather better than interest payments? If not, why would anyone take the risk? I've never noticed my capital deposits which produce interest, growing in value as I have my share.

Arb.

Define better!

If you have 100k on deposit and are paid 1k interest, you do not lose 1k in capital to compensate. With shares, every dividend per share payment you get comes straight out of the share price, so you gain nothing from a dividend payment! Which is better?

Share prices fluctuate and over the long term hopefully fluctuate in a nice way due to companies making profits. That's where your real return comes from with shares, not from dividends. All dividends do is return some of the capital value you have locked up in your shares portfolio to your bank account.

Bonds pay interest as well as deposits of course and again, interest payments do not come at the expense of the capital value of the bond, so the interest payments are real gains, unlike with dividends. The difference between bonds and deposits is that it is also possible to make capital gains from bonds, just like with shares. So bonds are better than shares and deposits

[dealtn]

It is worth considering whether the company paying the dividend could utilise the money itself better than the shareholder and the tax efficiency of either course.

And that decision changes over time.

For example would a gearbox or a fuel injection manufacturer serve its investors best by reinvesting in better products or paying a dividend to allow the investor to allocate that cash into a battery maker?

The former.

If the investor prefers to have a different proportion invested such that less was in "gearboxes" and more in "batteries" he can, at any time, reallocate by selling (some) shares in the former and buying (some) shares in the latter.

It isn't the gearbox companies job to be second guessing the capital allocation wishes of its investors (which won't be the same anyway).

[Lootman]

The price of a share does not 'have to drop' by the amount of the dividend, in fact often does not. You are confusing price with value. And of course where theory and practice diverge. Often the amount of the dividend has very little effect on the share price because it gets lost in market noise. It will affect the value of the share but that is a different matter.

That is true but only because the amount of each dividend payment is very small relative to the share price. If a share with a 4% yield pays 4 dividends a year then each payment is 1% of the share price, and that could indeed not be "lost in noise"

However sometimes the dividend is much larger, such as with a special dividend. Other times there are corporate actions that lead to signficant cash payouts. And in those cases you can very clearly see a big drop in share price.

It really could not be any other way, otherwise there would be a free lunch and we all know that the market doesn't give those out.

[OhNoNotimAgain]

Most people see the stock market as a very risky. Which it is in the short term so they avoid it.

However, anyone who can stomach the short-term capital volatility is rewarded by better long-term returns than from any other asset class.

And those returns come more from dividends than from capital growth.

The free lunch is the steady drip drip drip of compound interest over a long time on those dividends. Which most people are blissfully unaware of.

[dealtn]

Most people see the stock market as a very risky. Which it is in the short term so they avoid it.

However, anyone who can stomach the short-term capital volatility is rewarded by better long-term returns than from any other asset class.

And those returns come more from dividends than from capital growth.

The free lunch is the steady drip drip drip of compound interest over a long time on those dividends. Which most people are blissfully unaware of.

No. Those superior returns come from the reinvestment of those dividends, not from the dividends themselves. Exactly the same (in fact better due to lower frictional costs such as taxation and dealing charges) returns would occur if companies didn't pay those dividends but retained them and reinvested them themselves (as they typically do with a large portion of earnings).

It seems some are blissfully unaware of that distinction.

[Lootman]

And those returns come more from dividends than from capital growth.

The free lunch is the steady drip drip drip of compound interest over a long time on those dividends. Which most people are blissfully unaware of.

No, the bulk of returns come from gains. You can see this easily by subtracting the average dividend yield from the average annual total return.

So for example the US market yields about 1.5% and yet it has gained about 10% in total annually over a good number of years now.

And dividend reinvestment is not a "free lunch". If you do it then you have less spending money.

[tjh290633]

Impressed by what? There is no news, or information, on the XD day so any such share should move by the same as the market (adjusted for its beta).

But they seldom do.

TJH

[hiriskpaul]

None of the long term returns come from dividends as each dividend is paid for by a corresponding debit on share price. Taking dividends out and spending them detracts from long term returns.

[Hariseldon58]

It is worth considering whether the company paying the dividend could utilise the money itself better than the shareholder and the tax efficiency of either course.

And that decision changes over time.

For example would a gearbox or a fuel injection manufacturer serve its investors best by reinvesting in better products or paying a dividend to allow the investor to allocate that cash into a battery maker?

I owned a specialist engineering company, in the early years we were growing quickly and we reinvested heavily into the business ( and borrowed), as time went on we had found that the cyclical nature of our business, the geographic restrictions, limited market opportunities, technical changes, lack of appropriate labour meant that the business could either stagnate and be highly profitable or move to grow. Moving wasn’t an option , in the latter years we just threw off cash, couldn’t sensibly reinvest it in the business and thus used it to invest in public markets.

Retired early was the last stage… ( after sale and under new management the business was driven into closure within 3 years)

[dealtn]

Impressed by what? There is no news, or information, on the XD day so any such share should move by the same as the market (adjusted for its beta).

But they seldom do.

TJH

I would suggest share prices move much more frequently, and by larger, on the announcement days of dividends. Not because of the dividends themselves, but the accompanying results and market information on which future prospects and potential cashflows become known. On the xd day, whilst not exact due to noise, generally and on average individual shares typically move by the size of the dividend, and any approximate beta adjusted market move. The exceptions are typically when market relevant information by coincidence also coincides with that xd day.

[tjh290633]

If you have 100k on deposit and are paid 1k interest, you do not lose 1k in capital to compensate. With shares, every dividend per share payment you get comes straight out of the share price, so you gain nothing from a dividend payment! Which is better?

The shareholder is no worse off after receiving a dividend than if the company were to retain it. He still owns the same number of shares and has a cash payment as well.

The shareholder also has the opportunity to do something with that dividend payment. He could buy more shares of that company, buy shares in another company, mend his roof, go on a cruise, take his wife out for a meal, whatever.

What the shareholder gains is the opportunity to do what he pleases with his own money. The company might decide to waste it by buying back its own shares.

TJH

[tjh290633]

Impressed by what? There is no news, or information, on the XD day so any such share should move by the same as the market (adjusted for its beta).

But they seldom do.

TJH

I would suggest share prices move much more frequently, and by larger, on the announcement days of dividends. Not because of the dividends themselves, but the accompanying results and market information on which future prospects and potential cashflows become known. On the xd day, whilst not exact due to noise, generally and on average individual shares typically move by the size of the dividend, and any approximate beta adjusted market move. The exceptions are typically when market relevant information by coincidence also coincides with that xd day.

Market sentiment about a particular share can vary. News does not have to be disseminated on XD day to affect the share price.

TJH

[hiriskpaul]

If you have 100k on deposit and are paid 1k interest, you do not lose 1k in capital to compensate. With shares, every dividend per share payment you get comes straight out of the share price, so you gain nothing from a dividend payment! Which is better?

The shareholder is no worse off after receiving a dividend than if the company were to retain it. He still owns the same number of shares and has a cash payment as well.

All true, no worse off, but you have glossed over one important detail - the amount of the cash payment has come off the capital value of the shares. Number of shares held is nether here nor there. With a 5 to one share split you get 5 times the shares you started with, but each share has a fifth of its previous value.

The shareholder also has the opportunity to do something with that dividend payment. He could buy more shares of that company, buy shares in another company, mend his roof, go on a cruise, take his wife out for a meal, whatever.

What the shareholder gains is the opportunity to do what he pleases with his own money. The company might decide to waste it by buying back its own shares.

Again, not disputing any of that. Some investors may prefer the buy back as it increases their share of ownership and does not give rise to a taxable event. For investors like this who do want to reinvest, there is also a risk that the share price rises before the reinvestment takes place which makes them worse off than they might have been had the company done the wasted buy back at a lower price.

If a shareholder wants to take capital out of the share holding, they can always sell some shares. This gives a similar result to taking a dividend. The difference is the shareholder has fewer shares, but the remaining shares have not been diminished in value by the dividend payment.

[Arborbridge]

All true, the fallacy is in believing otherwise - that dividends are like interest payments. False assumptions based on the fallacy are not uncommon and are easy traps to fall into.

Ever come across statements such as "The share price has fallen, but that is OK provided the dividend is maintained"?

For another example, I was once sent a magazine by Hargreaves Lansdown discussing equity income funds and the article actually stated that share price falls were good as it meant the dividend payments bought more units when share prices were low. Utter nonsense of course, relying on the fallacy that dividend payments are equivalent to interest payments.

Hmm, maybe I'm naive, but aren't dividends rather better than interest payments? If not, why would anyone take the risk? I've never noticed my capital deposits which produce interest, growing in value as I have my share.

Arb.

They are both cash. What is different is the underlying investments, and their potential to generate cashflows. A cash payment from either has the same impact on your bank account.

You've avoided the point. The equity base grows over time, wheareas the usual fixed interest base doesn't. That is why dividends are more attractive to me than interest: they are not the same.

[OhNoNotimAgain]

And those returns come more from dividends than from capital growth.

The free lunch is the steady drip drip drip of compound interest over a long time on those dividends. Which most people are blissfully unaware of.

No, the bulk of returns come from gains. You can see this easily by subtracting the average dividend yield from the average annual total return.

So for example the US market yields about 1.5% and yet it has gained about 10% in total annually over a good number of years now.

And dividend reinvestment is not a "free lunch". If you do it then you have less spending money.

The importance of dividends in total equity returns was reinforced in the 2021 Barclays Equity Gilt Study.
It said that, before costs, £100 invested in the UK stock market in 1945 would now be worth £236 in real terms. But with dividends reinvested that £100 would have grown to £5,799.
Never, never understimate the power of compound interest.

[Lootman]

And those returns come more from dividends than from capital growth.

The free lunch is the steady drip drip drip of compound interest over a long time on those dividends. Which most people are blissfully unaware of.

No, the bulk of returns come from gains. You can see this easily by subtracting the average dividend yield from the average annual total return.

So for example the US market yields about 1.5% and yet it has gained about 10% in total annually over a good number of years now.

And dividend reinvestment is not a "free lunch". If you do it then you have less spending money.

The importance of dividends in total equity returns was reinforced in the 2021 Barclays Equity Gilt Study.

It said that, before costs, £100 invested in the UK stock market in 1945 would now be worth £236 in real terms. But with dividends reinvested that £100 would have grown to £5,799.

Never, never understimate the power of compound interest.

You know very well what is the critical flaw in that argument because it has been explained to you countless times.

Obviously if you invest more money and spend less, then your pot will grow more. That has nothing to do with the distribution of total return between growth and dividends.

Moreover the UK is an exception in that companies disgorge a lot of themselves as dividends. Your theory is even less true for markets that are more growth oriented e.g. the US and Asia.

[hiriskpaul]

And those returns come more from dividends than from capital growth.

The free lunch is the steady drip drip drip of compound interest over a long time on those dividends. Which most people are blissfully unaware of.

No, the bulk of returns come from gains. You can see this easily by subtracting the average dividend yield from the average annual total return.

So for example the US market yields about 1.5% and yet it has gained about 10% in total annually over a good number of years now.

And dividend reinvestment is not a "free lunch". If you do it then you have less spending money.

The importance of dividends in total equity returns was reinforced in the 2021 Barclays Equity Gilt Study.
It said that, before costs, £100 invested in the UK stock market in 1945 would now be worth £236 in real terms. But with dividends reinvested that £100 would have grown to £5,799.
Never, never understimate the power of compound interest.

This spin can be put the other way round. Don't take dividends out of the market and you would have got £5,799. Take them out, reducing the capital value each time you did and you would have only got £236.

[GoSeigen]

And those returns come more from dividends than from capital growth.

The free lunch is the steady drip drip drip of compound interest over a long time on those dividends. Which most people are blissfully unaware of.

No, the bulk of returns come from gains. You can see this easily by subtracting the average dividend yield from the average annual total return.

So for example the US market yields about 1.5% and yet it has gained about 10% in total annually over a good number of years now.

And dividend reinvestment is not a "free lunch". If you do it then you have less spending money.

The importance of dividends in total equity returns was reinforced in the 2021 Barclays Equity Gilt Study.
It said that, before costs, £100 invested in the UK stock market in 1945 would now be worth £236 in real terms. But with dividends reinvested that £100 would have grown to £5,799.
Never, never understimate the power of compound interest.

OMG this is even more bogus than the original MunroMan nominal returns claim! [Not to mention completely OT for the thread.]

I really think there was no need for the OP. Empirical evidence is really not needed here. The key point is that the only differrence between the shares trading cum-div and ex-div the following day is the right to receive the dividend. The value of the business is set by rational people trading, not any magical formula. Any rational buyer will deduct the amount of the dividend from the share price when buying ex-div because they have no right to receive the dividend; any rational seller will also deduct the amount of the dividend from the share price when selling ex-div because they do have the right to receive the dividend. No figures needed to prove or disprove this. It is correct almost by definition.

GS