Self-Control And Dividends

Here is a long-standing puzzle in traditional finance: Why do indi­viduals have a strong preference for cash dividends? This is especially puzzling considering that dividend income is taxed at a higher mar­ginal rate than capital gains.

Consider the example demonstrated in Table 14.1. You own 1,000 shares of a $100 stock (a total value of $100,000). If the stock pays a 1% dividend, then you receive $1,000 and the stock price falls to $99 per share (the 1,000 shares are now worth $99,000). The decrease in the stock price is the amount of the dividend paid. However, if you are in the 28% tax bracket, then you keep only $720 after taxes. In sum, you end up with $720 in cash and stock worth $99,000.

Now consider the alternative. Assume that the stock does not pay a dividend. If you want some cash, you must sell 10 shares at $100 a share to receive the $1,000 proceeds, thus creating your own divi­dend. This is called a homemade dividend. You are now left with 990 shares of a stock worth $100, for a total of $99,000. If the stock sold has no capital gains liability, then you owe no taxes and keep the entire $1,000 in cash. Note that you are better off creating your own dividend. If the stock had a cost basis of $50 a share and capital gains are taxed at 20%, then $100 is owed in taxes. You are still better off making your own dividends.

If you wish to maximize your wealth and cash flow, you should seek income through homemade dividends rather than cash divi­dends. However, people seem to prefer cash dividends. This behavior seems irrational in traditional finance, but it can be explained by investor psychology. Consider the following case:

Because of the steep rise in oil prices in 1973, Consolidated Edison Company of New York experienced a large decline in income. Consequently, that year they omitted paying the divi­dend, which had been paid for 89 consecutive years. At the 1974 annual meeting, angry shareholders confronted manage­ment, demanding a restoration of the dividend. Widows queried, "Who is going to pay my rent?" People claimed that they were going to have to survive on only their Social Security checks.

 

		Received	Homemade   \
		Dividend	Dividend
Starting number of shares owned		1,000	1,000        i
Beginning price per share		$100	$100   I
Beginning stock value		$100,000	$100,000     i
Per share dividend		$1	$0        I
Pretax dividend income		$1,000
Dividend by selling 10 shares
Selling shares pretax income			$1,000        |
Ending number of shares		1,000	990        j
Price per share		$99	$100        |
Ending stock value		$99,000	$99,000        I
Taxes
Income Tax (28% marginal rate)		$280	$0        I
Capital Gains Tax (20% rate.	50% gain)	$0	$100        j
After Tax Income		$720	$900        j

 

Why didn't these people simply create homemade dividends? There are two psychological traits that explain this behavior: mental accounting and self-control. First, making homemade dividends probably didn't even occur to these investors. Mental accounting (Chapter 8) causes investors to separate investments into different mental accounts. When investing for income, investors buy high-dividend stocks, bonds, and annuities (Chapter 9). A different men­tal account and investment strategy is used for capital gains. It is difficult to think of a stock in the income mental account as having the potential to capture a capital gain.

These mental accounts can be useful for investors who need to exert self-control. A retired person may recognize that her wealth needs to outlive her—i.e., she doesn't want to outlive her money. Because she may be tempted to spend too much money, she enacts a common rule of thumb to help with self-control: never touch the principal. This rule is a helpful reminder to avoid overspending. However, it can also inhibit creative thinking that increases income—like homemade dividends. Therefore, sometimes it pays to bend the rules a bit.

 

SUMMING UP

You may need to invoke self-control management techniques, such as making rules of thumb and controlling your investment environment. These techniques can help you avoid the mistakes caused by letting your emotions and psychological biases influence your investment decisions. However, you should also understand why the rules exist and be able to bend them if creative thinking allows you to increase your wealth. Chapter 15 reviews your psychological biases and proposes some specific strategies, rules of thumb, and manage­ment techniques that help you to overcome those biases to improve your wealth.