Common Misconceptions About Dividend Investing

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton.

Does dividend investing create bad investor behavior? This strategy can split investors into two camps, those in favor and those against. Here’s how it works. A company will pay out part of its earnings to stock owners, typically quarterly. Those dividends can arrive as a check in the mail or cash in a brokerage account. Critics say this isn’t a bonus, but a cut into the total return. But income-focused investors don’t seem to mind.

David Harrell is the editor of Morningstar’s DividendInvestor newsletter. We talked about the psychology of dividends.

Welcome back to the podcast, David.

David Harrell: Thanks for having me back.

Hampton: Let’s start with why dividend investing has divided so many investors.

Why Investors Are Divided About Dividend Investing

Harrell: I’m not sure if investors are divided. As an editor of a dividend-oriented newsletter, certainly I hear from investors that are very pro-dividend investing. But I think if investors are divided or maybe sometimes confused, it’s because they’re getting mixed messages about dividends. If you read the financial headlines, you see the news. Like, earlier this year, I think we spoke about, you had some big-name companies initiating dividends for the first time, Meta Platforms and Alphabet. In often cases, that was praised as a good thing. You see headlines about dividend increases. That’s generally viewed as positive. There’s this whole idea of dividend growth investing by identifying companies that are growing their dividends at a regular pace. That’s indicative of companies with strong growing earnings. That’s considered positive. There’s also this idea that dividend stocks can be defensive in recessionary periods. Those are all pro-dividend messages.

At the same time, you often see stories about how dividends are an inefficient way for companies to return cash to their shareholders. And that maybe investors are irrational in pursuing a dividend-focused strategy as opposed to a total-return-based strategy. For that reason, I feel even though investors are divided, but sometimes they’re getting two stories there and they’re not maybe sure what’s going on with dividends.

The Pitfalls of Dividend Fallacy

Hampton: Good point. Talk about a couple of pitfalls that income-focused investors should be aware of. There’s dividend fallacy. What’s going on there?

Harrell: The dividend fallacy, if you’ll bear with me, we’re only a couple of weeks past Halloween. Maybe you’ve got some Halloween candy floating around your house still. Let’s say that you and I went trick or treating and we each had some of those full-size candy bars left. Let’s say that my full-size candy bar, same as yours, represents one stock share for a dividend-paying company. You have the same candy bar, but yours is going to represent a non-dividend-paying stock. The dividend fallacy comes into play where this idea that I have my chocolate bar and when I get my dividend, it’s like in addition to my full-size chocolate bar, I’m getting the most little mini chocolate bars, the bite size. Now, I’ve got my full-size and my bite-size. You’ve only got your full-size, so I’ve got more chocolate than you, so I’m better off than you.

What investors don’t realize is that stock prices do adjust for those dividends that are paid. I might have a full-size bar and a bite-size, but my full-size bar has shrunk just a little bit and I have the same amount of chocolate as before. So, you and I have the same amount of chocolate, but my fallacy is that I’ve got a little piece that you don’t have, so I somehow have more.

The challenge here, of course, is that stocks aren’t candy bars. Stock prices go up, they go down, so those candy bars are always shrinking—or growing, hopefully. You might not realize it—that this dividend payment has caused a little bit of a shrinkage for you, but in fact, it does. That really is the dividend fallacy—that you’re getting the dividend payment on top of the capital gain, so that the dividend-paying stocks will always be giving you more in total, and that’s not necessarily the case.

The dividend fallacy also can occur when people think about the defensive nature of dividend stocks. There is a case that dividend-paying stocks are defensive—because the types of stocks that pay dividends, they tend to be large-cap, more value-oriented companies, established firms from certain sectors—so when you have a broad market downturn, those sectors sometimes hold up a little better, so there’s a defensive component to the dividend stock. But I sometimes hear people say, “Well, the dividend payment dampens volatility,” and that’s a second-order dividend fallacy because the dividend payment also did result in a change in the share price. So it’s fair to say that dividend stocks in certain recessionary environments can be defensive, but the idea that the dividend payment is what’s dampening volatility is not correct.

Warning Signal for Dividend Traps

Hampton: What about dividend traps? Yields can look too good to be true, but that’s typically a warning signal, right?

Harrell: It can be. This is really the danger of buying stocks based on one metric or one number. You’re looking at stock, and stock A is yielding 3.5%, and stock B is yielding 6%. You’re like, “Oh, well, I’m going to buy stock B. It must be a better purchase.” And it could be. But sometimes there are what you refer to as dividend traps, and this is a situation where if we think about how yield is calculated—it’s a very simple calculation, it’s the current dividend rate of the stock divided by the share price—but if that share price starts to crater, to go down because the denominator is getting smaller and smaller, the resulting yield is going to be higher and higher. If you see a high-yielding stock, it could just be a great company that’s paying out a lot of its earnings as a dividend, and it could be a good investment. It could also be a company that has seen its yield being pushed up by declining share price. That declining share price might represent some fundamental challenge to the company’s business model, and it might even indicate that there’s a dividend cut coming into the future. So, buying on yield alone can be a dangerous strategy.

Should Investors Focus on Total Return Rather Than Dividends?

Hampton: A popular argument is that investors should be indifferent to a company’s dividend policy. Explain why?

Harrell: Sort of think about how you make money from stocks. There’s really two components here. One is the capital gain. You buy the share for $100, it goes up to $200, and you can sell and you realize a $100 gain. You can also receive dividends from the stock, and that obviously counts in your favor as part of your total return. The argument that investors should be indifferent is not a new one. There was a landmark paper on this in 1961. But really the idea is that investors should be focused on total return instead of dividends alone. And that dividends, if you really need current income, you always have the option to create your own dividend by selling some of your shares. That you can do so at the time of your choosing, whereas dividends are coming quarterly whether or not you want them. So that’s the, it’s not the dividend fallacy, but it’s the idea that a dollar is a dollar, whether it comes from a dollar of dividends or it comes from you realizing a dollar by selling a share or a portion of a share.

How a Dividend-Focused Investment Strategy Can Help With Safe Withdrawal Rates

Hampton: And you’ve written a column in Morningstar’s DividendInvestor newsletter that supported a dividend-focused investment strategy. You pointed out that investors could sidestep the safe withdrawal rate dilemma. Talk about that.

Harrell: Well, I’m not an expert on withdrawal rates. I’ll leave that to colleagues like Christine Benz and such. I guess my point there was that—people often reference the Trinity study, which shows that a 4% withdrawal rate is a safe withdrawal rate for a 30-year time period—but then there’s a lot of discussion about that is like, “Well, what if you have a 40-year retirement period, expected retirement?” “What if price multiples are very high right now?”–all sorts of things. And I’m not advocating this necessarily as this is be-all and end-all for an investment strategy, but it does sidestep the issue of making withdrawals, that if you have a diversified portfolio of dividend stocks that’s providing a yield of say 3.5% or 4%, you are essentially able to get that amount of income from the portfolio without having to make sell decisions on an ongoing basis.

Why Investors May Not Want to Create Their Own Dividend

Hampton: And you mentioned this earlier, the idea of creating your own dividend. Why do you think some folks may not find that as appealing?

Harrell: I think it’s—there’s a lot of psychology here. And one is that, you get the check in the mail or you get the dollar showing up in your brokerage statement with a dividend. And it’s sort of taken out of your hands. There’s plenty of investment or decision regret when it comes to investing. So you do have that option of creating your own dividend at any time. You can sell a share, you can sell fractions of shares now very easily with many brokerage platforms. So you always have this option to create income by selling shares of stocks that you own. But that creates a whole other set of questions: Which shares do you sell from your portfolio? Then do you have subsequent decision regret because, “Oh, I sold those shares and now those shares have gone up.” And I’m not suggesting in any way that you settle for a suboptimal strategy or anything like that, but simply saying from a psychological standpoint: Dividend investors don’t face those questions because they are receiving that regular income from their portfolio without having to sell shares.

Why Long-Term Performance Matters When Looking at Dividend Stocks Versus the Broader Market

Hampton: And we’ve talked before about dividend stocks versus the broader market. Morningstar has done research that shows why investors may want to think long term when comparing performance. What do you say?

Harrell: Well, yes. I was recently looking at the Robert Shiller numbers, which date back to the late 1800s. So we have a very long-term record of US large-cap companies in terms of their earnings, how their earnings have grown, and the dividends that they’ve paid out on a monthly basis going back basically 150 years. And if you look at the dividends as a portion of earnings, we’re in a different place today than we were in the midpoint of the 20th century, for example, where companies are paying out a smaller portion of their earnings as dividends. And there’s multiple factors here. One is the rise of buybacks or share repurchases as a way of returning cash to shareholders. And it’s also that, over the past 10, 15, 20 years, a lot of the market capitalization and US equity returns have been driven by these mega-cap growth companies, tech and communication services firms that have opted not to pay dividends.

You can slice and dice it in many different ways. I know there’s some Ken French data that Morningstar’s indexes team cited in the study, looking from the late ‘20s through 2023, and they found that higher-yielding stocks actually had the best return and beat that over the broad market. I was looking at a shorter time period, the 20-year period that ended in 2023, and dividend stocks, or dividend indexes, did slightly outperform the broad market. If you look at rolling returns for the past 30 years, particularly the past five or 10 years, we see that the broad market has outperformed a dividend-focused portfolio index, and precisely because a lot of that market return has been driven by some of these big-name tech and communication services firms, which until recently many of them were not paying dividends, but as we spoke about before, we now have Meta Platforms, Alphabet paying dividends, and I think if you look at the top 10 companies by market capitalization right now, Amazon.com might be the only holdout for paying a dividend. Now, keep in mind that the yields of these companies is relatively low, below 1% for Apple, Microsoft, Alphabet, and Meta Platforms. So they’re not typically going to show up in a dividend-focused portfolio or dividend index, but we are seeing more companies paying dividends at this point, at least relative to where we were even a year ago.

Are Share Repurchases Better Than Dividends at Returning Capital to Stock Owners?

Hampton: Are share repurchases a better way to return capital to stock owners?

Harrell: The argument there is that share repurchases are a more efficient way of returning cash to shareholders. So if you own a dividend-paying stock in a taxable account, if it’s a qualified dividend, at the very least you’re going to pay the capital gains rate, tax rate, on that dividend. Even if you reinvest your shares, you’re going to have a tax bill for that. With share repurchases, where the company takes their cash and instead of distributing it as a dividend to shareholders, they instead buy shares from the market, they reduce their share count. And how this benefits the remaining shareholders is that now there are fewer shares to spread their earnings across. In theory, all else being equal in terms of the price multiple, you should see a corresponding increase in the share price. In that sense, as a shareholder, you benefit because now your shares are worth a little bit more, but there’s no tax implication until you go to sell those shares. So that’s why people say that buybacks or repurchases are more tax-efficient relative to dividends.

Drawbacks of a Dividend-Focused Investment Strategy

Hampton: So let’s turn to tables now. What are a couple of points that you can make against a dividend-focused investment strategy?

Harrell: I think the main one would be the one I mentioned earlier, where investors are attracted to companies based solely on the yield. They’re not looking at valuation. They’re not looking at potential earnings growth or anything else. They’re just saying, “Wow, 5%, 6% yield, let me buy that.”

The second is that you could, in pursuit of yield, assemble a portfolio that doesn’t capture some of the areas of the market where future returns might be greater, that you’re very light in some of the industries or sectors that are going to provide the greatest total return going forward. Now, what that is, we don’t know. So I would say that’s sort of the main drawback.

And then if you are years away from retirement and you don’t need the current income, there is the tax-inefficiency argument there. But I would back away from that by saying that we spend a lot of time, or at least perhaps I do, too much time, looking at what are dividend strategies doing relative to the broad market. And first of all, I have heard from subscribers and such that—”I don’t really care about the broad market. I’m looking to fund my retirement and I have a growing stream of dividends and it does that. I’m happy with that.”

So that’s one point. But I think also is that we don’t invest in the abstract. The idea is, yes, you want to maximize your total return, but the success of an investor is based on several things, and one of them is their behavior. And I don’t think we need to come down hard on one side or the other in that if pursuing a dividend-focused investment strategy causes you to maximize your savings and investment and it gets you to your goals, then that’s a perfect strategy for you. If a strategy that you’re not focused on current income, but rather total return, if that gets you to your goals, that’s a great outcome as well.

So I think we spend a lot of time in the abstract. Dividends, did they outperform? Dividend stocks outperform or underperform the broad market and perhaps less attention to: Do investors behave in such a way because of the stocks that they want to purchase? Do they behave in such a way that allows them to reach their financial goals?

Has Dividend Investing Created Bad Investor Behavior?

Hampton: I was going to pose this question to you, but I think you just answered it. Because I started this show asking whether dividend investing has created bad investor behavior, but what say you?

Harrell: I think it occasionally does in individual purchases where people purchase for yield alone, but I wouldn’t say that it necessarily creates bad investor behavior. And then we are looking at historical time periods, and the vast majority of the data that we have looking over the 20th century, dividends were a very large component of total return. We’ve seen less of that in recent years, but I wouldn’t want to necessarily predict what we’re going to see in the future. But I think it doesn’t have to be an either/or approach that investors who desire current income, who want the stability of the cash flow from a dividend portfolio, it makes perfect sense for and that might be a great investment strategy for them. And if that doesn’t appeal to them, they don’t have to pursue a dividend strategy, but we can have good outcomes with both approaches.

Hampton: So pick what’s going to keep you motivated.

Harrell: I think so. And I think that’s the one thing about dividends is that investors, the very active investing is your forgoing current consumption to fund some future goal, be it retirement or children’s college education, whatever that might be. And it’s sometimes hard to stay motivated because it’s something that’s 10, 15, 20, 30 years down the line.

One thing about dividends is there’s this tangible aspect to investing. You start to receive an income stream, and you can match that income stream to some of your liabilities. And I’ve seen on social media, “Well, now my dividend, my monthly dividend payments, they pay for my phone bill. Next month, I’m going to have enough, they’re going to pay for my car payment” or something like that. So it’s causing positive investor behavior because they’re motivated to increase that dividend stream for themselves. So I think that’s a very positive aspect of dividends. Again, you can, you could possibly do the same thing by creating your own dividend. But I don’t think investors, because it’s less tangible, I don’t see the same excitement from that, from the create your own dividend that you do with some dividend enthusiasts.

Hampton: David, thank you for coming to the table and explaining the psychology behind dividend.

Harrell: Thanks for having me.

Hampton: That wraps up this week’s episode. Thanks for watching and making this show part of your day. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to Senior Video Producer Jake Vankersen and Associate Multimedia Editor Jessica Bebel. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.

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The author or authors do own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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