The Mystery Of Dividend Preference And The ‘Spend Dividends Only’ Strategy

A good many retirees seem to be enamored with the “Spend Interest and Dividends Only” strategy for spending down their retirement savings. The foundation of this strategy is a preference for the value of a dollar generated from dividends over the value of a dollar generated from the sale of stock, or capital gains.

This preference has long been recognized but never quite understood.

The reason for this preference for dividends is so confounding that economists in the field of behavioral finance find it an interesting research topic. One of those researchers is Samuel Hartzmark, an Associate Professor of Finance at the University of Chicago’s Booth School of Business.

Hartzmark thinks dividends fall under the category of mental accounting. He describes a “free dividend fallacy”, in which investors view dividends as a source of return that is independent of the price of the stock when in reality the price of the stock is immediately reduced by the value of the dividend when it is paid. This fosters the mistaken belief that dividends are the same as bond interest.

Samuel Hartzmark describes a “free dividend fallacy” in which investors view dividends as a source of return that is independent of the price of the stock.

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This false equivalence of bond interest and dividends probably influences some investors to turn to high-dividend stocks when bond interest is low without considering the additional risk that equities bring. They are not the same, of course. When a $10,000 bond pays out $300 in interest, the bondholder is still owed $10,000 in principal at the bond’s maturity date. When $10,000 of stock pays out $300 in dividends, the value of the remaining stock immediately drops to $9,700 at payout. Unlike bonds, there is no “maturity date” or any promise of the stock’s value at some future date.

In fact, there are tax advantages to generating income with capital gains in a taxable account, despite the fact that qualified dividends and capital gains are currently taxed at the same rate. The investor can postpone capital gains tax until the funds are actually needed whereas a cash dividend (the most common type) will be immediately taxable when the company decides to issue it. An added bonus of capital gains is the ability to minimize taxes by selling specific lots.

In a post entitled, “Buffett: You Want a Dividend? Go Make Your Own,”[1] Motley Fool describes Warren Buffett’s explanation for Berkshire Hathaway’s refusal to pay dividends and how it is actually more efficient for both Berkshire and their shareholders if shareholders “create their own dividends” by selling shares.

In “Vanguard Debunks Dividend Myth”[2], financial researcher Larry Swedroe notes,

But this preference isn’t entirely new; it has long been known many investors have a preference for cash dividends. From the perspective of classical financial theory, this behavior is an anomaly.

It’s an anomaly because dividend policy should be irrelevant to stock returns, as Merton Miller and Franco Modigliani famously established in their 1961 paper ‘Dividend Policy, Growth, and the Valuation of Shares.‘”

Swedroe further notes that concentrating on dividend-producing stocks reduces diversification benefits. Concentrating is a key word here because adding some dividend-producing stocks to a portfolio can increase diversification. Said differently, there is nothing wrong with dividend-producing stocks but investing in only those stocks can be hazardous to your portfolio’s health. As is often the case, too much of a good thing is too much.

Swedroe concludes that “both theory and historical evidence demonstrate there isn’t anything unique about dividends.”

Strategies have been proposed to eliminate sequence of returns risk with high-dividend stocks. This wouldn’t have occurred to me because sequence risk is caused by systematically selling stocks when prices are low. Cash dividends don’t avoid sales at low prices; they are effectively a forced sale that will occur regardless of the stock’s price and with timing decided by the company.

A recent series of three posts at the EarlyRetirementNow blog entitled “The Yield Illusion: How Can a High-Dividend Portfolio Exacerbate Sequence Risk?,”[3] shows that a high dividend yielding portfolio doesn’t mitigate sequence risk and can, in fact, exacerbate it.

As always, the bottom line is what a retiree should do with this knowledge. My advising philosophy is that so long as a household understands a strategy and its alternatives, they should do what makes them comfortable.

I once had a client say, “I know I am behaving irrationally but this is what I am most comfortable doing.” I don’t know how I can argue with that or even if I should. As Michael Finke says, our job as advisors is to make clients happy.

Furthermore, there is no way to prove that even a poor strategy won’t turn out well or a good one poorly for an individual household. We can only say what is probably a good or poor bet.

But, if you plan to spend down retirement savings with a strategy based on preferring a dollar of dividends to a dollar of capital gains, you are betting against economic theory, portfolio theory, historical evidence, tax law, behavioral finance and the wisdom of Warren Buffett.

Then again, maybe you will be lucky.


[1] Buffett: You Want a Dividend? Go Make Your Own, Motley Fool.

[2] Vanguard Debunks Dividend Myth, Larry Swedroe.

[3]  The Yield Illusion: How Can a High-Dividend Portfolio Exacerbate Sequence Risk?, EarlyRetirementNow blog.


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