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Financial Industry Insights from Advisors Asset Management
On August 10, 2017
Are Dividends Free?
Over the past year I’ve noticed a general misconception about how dividends work. Specifically, a misunderstanding of the tradeoff between share price and dividend payout. Any financial textbook would tell you on the day a dividend is paid, the share price should fall by the amount of the dividend. But what I’ve noticed is that it seems dividends are being thought of as something similar to interest payments from a bond; free money given to you on top of your capital. A few times I’ve noticed them not being considered in return calculations. These ideas can cause a great deal of investor consternation. So I looked into this, and I found this isn’t particular to my small sample. Recently, a study by Professors Samuel Hartzmark from Chicago Booth School of Business and David Solomon from the Marshall School of Business at USC was published showing how both retail and institutional investors commit what the study calls the “free dividends fallacy.” It makes it clear that this is a market-wide problem. My goal for this article is to cover how to properly think about dividend positions, and point out the costs of not doing so.
Example: Vanderco’s stock trades at $10, then it pays out a dividend of $1, and the stock now trades at $9. That $1 of earnings was transferred from Vanderco to the shareholder.
The example is simple, and looks great on paper, but real life daily price fluctuations make this tradeoff pattern easy to miss. Looking at actual market data, we see that on the day a dividend is paid the correlation between daily price change and dividend yield is -0.50 (far from the theoretical -1). The further out we push the time period, the more the correlation approaches zero (no correlation) (Hartzmark, Samuel M).
So did the price drop by the value of the dividend? Yes it did, but lots of other things are taking place simultaneously, such as market movements, new information, and idiosyncratic price changes – all of which come together to lower the correlation we actually see. Back to the example, Vanderco now has less equity on its balance sheet, and thus its stock trades at a lower price. The share value of the investor’s Vanderco position decreased, but the investor now has more funds available for trading in their brokerage account. No wealth was created, only moved/relabeled.
Fallacy’s real market effects
In short, dividends are not free and not to be taken for granted. They are just one part of a portfolio’s total return, but they can be pretty significant. During our current bull market (3/9/2009 – 7/25/2017) dividends have accounted for 21% of the S&P 500 total return. If we look back at approximately the last 20 years (7/25/1997 – 7/21/2017), dividends made up 44% of the S&P 500’s total return (source: Bloomberg). As pointed out earlier, buying into dividend payers when the demand for dividends is high, may cause investors to earn 2 to 4% less than what might normally be achieved. With the markets attention on growth, and FANG stocks showering the news, now may be a good time to rethink dividends. Just don’t make some of the mistakes highlighted in the study and we believe you should be well on your way to greater investment success.
Hartzmark, Samuel M. "The Dividend Disconnect." SSRN Electronic Journal (2016): n. pag. Web.
CRN: 2017-0803-6080 R
Data represents past performance, which is no guarantee of future results.
Advisors Asset Management, Inc. (AAM) was not involved with the preparation of third party articles linked to on this page and the opinions expressed in those articles are not necessarily those of AAM.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.
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