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ECONOMICS & INVESTMENT MANAGEMENT

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | MARCH 2017

22

The Worst Investment Mistake and a Simple Solution by Daniel Myers, CFA, CFP

Vol. 71, No. 2 | pp. 22-27

This issue of the Journal went to press in February 2017. Copyright © 2017, Society of Financial Service Professionals. All rights reserved.

ABSTRACT

When clients transfer their focus to the div-

idend stream instead of the daily changes

in total portfolio value, they will trade much

less and by doing so, do much better. This

is because they will be letting investment

returns stem from the long-term portfolio

growth of the underlying investments’ val-

ue as opposed to short-term valuation and

subsequent trading decisions. Dividend in-

vesting can provide clients with a “noise fil-

ter” that rightly steers clients away from the

daily headlines. It is a commitment device

that keeps investors from selling premature-

ly. And it offers stability: Dividend payments

are a less-volatile stream of returns com-

pared to capital gains.

Isaac Newton said it best: “I can calculate the motion of heavenly bodies, but not the madness of people.”1 If one of the smartest people in world histo- ry cannot explain why people do what they do, I will not try. We can do all the math in the world to jus- tify our choices and support our decisions, but if we cannot control our emotions, then we are sunk. In in- vesting, it is no different. Here’s what we know about investor behavior: They save too little, they start too late in life, and they are not aggressive enough (over the long-term). Furthermore, they buy and sell at the worst times in market cycles. In this column, I will give you one solution to handle the problem of this irrational behavior: Use dividends as a commitment device to keep investors from hurting themselves. Unless you practice high-level quantitative finance, the math of investing (and wealth building) is fairly simple. The psychology of decision-making is not. It is emotionally hard for many investors to make ra- tional choices with certainty when we have imper- fect information. Ultimately, investing, like life, is all about making choices.

How to Deal with Uncertainty “It’s tough to make predictions, especially about the future.”—Yogi Berra2

Choices carry implicit predictions about future events. Many decisions are minor and relatively in- consequential, such as where to get lunch. Others

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JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | MARCH 2017

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have enormous consequences, such as selling out our stock portfolios and going to all cash. In investing, people have to make decisions every day: to buy, sell, or stand pat. Just like in Benjamin Graham’s “Mr. Market” allegory, we are free to ignore the daily gyra- tions of the market, or to buy or sell as it suits us.3

The stock market is a no-called-strike game. You don’t have to swing at everything—you can wait for your pitch. The problem when you’re a money manager is that your fans keep yelling, “Swing, you bum!”—Warren Buffett4

The more frequently investors have to make deci- sions, the more likely they are to make many bad deci- sions. This is especially true when you add complexity and emotionally charged influences into the mix. Stock market predictions are notoriously diffi- cult for a variety of reasons. The more predictions an investor makes about stocks’ direction, the more fre- quently they are likely to be wrong. If you are invested in a good asset class, such as stocks (for the long term), then the most important thing is to not screw it up. An old Wall Street maxim states that, “Time in the market is more important that timing the market.”

“I don’t look to jump over seven-foot bars: I look around for one-foot bars that I can step over.” —Warren Buffett5

“The Dow will be at 30,000 by 2020,” is a sev- en-foot-bar prediction. This is a lot harder prediction to make than the one-foot-bar prediction: “S&P 500 dividend payments next year will be pretty close to this year’s, probably with a little growth.” With dividend-centric investing, investors don’t have to make as many of these difficult predictions. They are enticed simply to get invested and stay in- vested because that is they only way to receive their dividends. Even if the attraction of dividend income simply tricks people into holding on to their stocks during crashes, instead of selling low and buying back higher as many do, then it has done a great job of helping people avoid a major pitfall of investors. The famous Dalbar Study shows us that investors typically make ill-timed trading decisions that lead

to underperforming the investments they own by a significant margin.6 Yes, you heard that correctly. Dividends can provide: 1. A noise filter—The next time you hear the fol-

lowing fears from the media, ask yourself (and your client) if stocks are likely to continue to pay dividends: “What a Trump win means for the stock market.” “Interest rates are set to rise.” “P/E ratios are stretched.” “We might have a recession; stocks are going to zero!” Who cares?! If your focus is on the dividend stream, then you’d be happy that stocks went down (assuming you’re reinvesting dividends), as your yield and there- fore return is ultimately higher. It emotionally helps you to buy low. Per Joe Rosenberg, former chief investment officer, Loews Corp, “You can have cheap equity prices or good news, but you can’t have both at the same time.”7

2. A commitment device—Dividend income may keep existing investors from selling premature- ly, especially during times of market stress, if framed (i.e., presented) as such for clients.

3. A growing annuity stream—By framing dividends as the central figure in a portfolio, as opposed to an afterthought, advisors can entice new inves- tors to start investing in stocks to gain the equity premium over bonds, which have a static income stream, or cash, which loses value daily.

4. Lower volatility—Dividend payments are a less volatile stream of returns compared with capi- tal gains. Dividend stocks are less volatile than non-dividend-paying stocks. This is even forget- ting returns, which have actually been higher. Many investors prefer lower-volatility portfolios to higher ones.

Question: Why do we make dumb investment decisions (buy high and sell low)? Answer: We are missing our noise filters. Media add tremendously to the stream of infor- mation presented to investors daily. Many of us are drawn unwittingly into this white noise. We subcon- sciously believe that this barrage of data must be im-

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A Growth Annuity Dividend reinvestment (especially for those in the accumulation phase) acts as a secondary commit- ment device as investors can watch their cash flow stream grow quarterly or even monthly (depending on portfolio structure) by the compounding of the re- investment as well as periodic raising of the dividends by the companies, not to mention the extra bump from periodic savings. That is an enticing pitch to investors, new and seasoned alike. Investors logically would want to trade their stocks less often, thereby not losing profits from badly timed trading decisions.

Newer Investors We know that dividend clientele generally com- prise older individuals in lower income tax brackets who prefer equity income returns and a relatively high- er net yield.10 Some may be surprised to learn that it is not only older investors who might prefer dividends. As an instructor for a personal finance class, I have students do a project in which they invest their hypothetical 401(k) as “new employees.” They have to choose their asset allocation based on their risk tolerance with a relatively conservative default 60/40 stock/bond split for an average risk tolerance. In my unscientific sample of hundreds of students I have had in this class, there is an extremely high level of risk aversion among many students. They commonly choose 70 percent to 90 percent bonds or cash for fear of losing all their money in stocks. I categorize risk tolerance between subjective (i.e., how you feel) versus objective factors (age, education, income, etc.), and these students typically should be considered highly risk tolerant based on objective factors (e.g., a 23-year-old college student wanting 10 percent stocks only, even after seeing long-term returns). Re- gardless, they self-select into very low risk-tolerance categories perhaps due to (irrational) fear. I suspect that if they understood that stocks could be a source of regular and growing income stream, then they could be enticed to invest more in stocks and in do- ing so capture more of the equity premium as well as

portant since the press gives out so much of it and that therefore we should use it to make regular trading decisions. We are essentially told that it is normal for the smartest and best investors to aggregate all data (whether or not it’s actually relevant), and use it to constantly tweak our portfolios. We are led to believe that because media report it on CNBC or Bloomberg, it must be important. This belief causes many of us to all too frequently make money-losing trades.8

For myself, I sometimes get sensory overload from the loads of data on such varied topics from political news, the state of the economy, direction of interest rates, and potential monetary and fiscal policy changes. When this happens, I remind myself of Benjamin Graham’s quote: “The vast majority of stock traders are inevitably doomed to failure.”9 Not wanting to be doomed to failure, I took in- ventory of my own trading (not simply investment decisions), and I found that the more frequently I traded, the worse my overall results were. As sad as it was to my ego, I was just as bad as everyone else at trading. I found that when I transferred my focus to the dividend stream instead of the daily changes in total portfolio value, I traded much less and by doing so did much better—letting investment returns stem from long-term portfolio growth of the underlying investments’ value as opposed to my short-term valu- ation and subsequent trading decisions.

Dividends Act as a Commitment Device for Investors One solution to the trading temptation is to design portfolios to prevent excessive (or even any) trading by investors. Dividend-centric investing is one solution to this trading problem. Similar to homeowners be- ing required to pay off their mortgage monthly or risk losing their house, and thereby becoming wealthier over time, dividend investors’ incentive is not to trade in order to receive dividends, as investors must hold the stock to receive the dividend. If they sell, they cut off the dividend stream. There are much worse addic- tions inside the financial world than dividends.

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come and for short-term capital gains, which is taxed at the person’s marginal income tax rate.

3. Companies that pay dividends have no better way to invest back into the business.13

Rebuttal: Actually, the research shows that even with lower volatility (see below), dividend payers’ returns are higher than nondividend stocks.14

It’s the Sharpe Ratio, Stupid Most of us prefer more certainty to less, and lower risk investments to higher risk, given equal returns. Notice the striking contrast in how the Sharpe Ratios differ when comparing the capital gains alone versus just the dividends in Table 1. Who wouldn’t want that return for their portfolio? Intuitively, many investors prefer dividends, albeit with criticism from professional investors, but this shows that the risk-adjusted return for dividends on a stand-alone basis is a logical choice. Unfortunately, investors cannot strictly receive the dividend stream and instead have to own the more risky capital gain stream, like it or not. Table 2 illustrates the risk/return profile of the S&P 500, separating capital gains (shown inde- pendently of dividends) and total return with divi- dends included.15 By simple deduction, we see here that dividends add significantly to the return (+4.31 percent) without adding much to the risk (+0.67 percent of standard deviation), concluding that the risk-adjusted return portion of the portfolio attrib- utable to dividends is much better than that of cap- ital gains; therefore it appears to be a rational choice to prefer dividends. This is contrary to the common rationale that (1) return is indifferent between divi- dends and capital gains or (2) that there is no rational reason for investors to prefer dividends. If you get a much higher risk-adjusted return (and you are risk averse), then you would prefer that investment.

What about Synthetic Dividends? Many researchers contend that investors could always create synthetic dividends by systematically

trade less and not fall victim to the trading mistakes many investors tend to do. Academic studies agree: Behavioral biases such as mental accounting and lack of self-control may also influence investors’ preference for dividends if investors keep dividends and capital gains in separate mental accounts.11 Almost every investor I have ever met uses mental accounting at some level and also succumbs to a bit of lack of self-control.

A Logical Preference for Dividends? Inconceivable! In the past, many researchers have theorized that a dividend-centric investment approach is illog- ical and that dividends and capital gains spend the same.12 This thought stems from several main ideas. 1. Investors can create synthetic dividends by sell-

ing off shares periodically. Rebuttal: Companies set dividend policy, and

they are usually very stable. Conversely, markets determine share prices, which are more volatile, leading to uncertain cash flow streams. When companies repurchase shares versus pay divi- dends, they take the opportunity away from the investor as to what to do with his or her share of corporate profits.

2. Dividends are taxed at a higher rate than unreal- ized capital gains.

Rebuttal: This is partially true as unrealized cap- ital gains are not taxed at all (until a sale triggers a tax), while the highest marginal rates for div- idends are 23.8 percent (20 percent federal plus 3.8 percent net investment income tax). However, many investors won’t have to even pay this tax, because they are in the lower tax brackets and pay either a 15 percent rate or even 0 percent. While politicians typically believe wealth equates to high taxable income, there are many millionaires in lower tax brackets, such as retirees with low- er taxable income, but with large equity in their homes and large 401(k) balances. In addition, the tax treatment is much better than for bond in-

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nally. I suspect that this creates an internal bias to make internal investments and expand revenues even if dividends are a better option than poorly thought- out corporate investments, perhaps to justify their high salaries. Case in point: Berkshire Hathaway has a policy to pay dividends only if they cannot find investments that they believe are better than the shareholders could find on their own. This requires a whole lot of trust on the part of shareholders, and Warren Buffett knows this. I believe Buffett to be one of the best managers in corporate America over the last half-century if not longer, but I do not car- ry this level of trust to every corporate manager who says, “Trust me; I’m the best caretaker of your mon- ey.” There are few truly great investors (only a hand- ful of fund managers beat the S&P 500, on average, over time). I can’t conceive that every single CEO of a public company is one of the great ones, even though their dividend policies tell me that they claim to be great investors. Like most people, when given the choice, I choose to receive payments sooner rather than later, and I therefore get the choice on where to invest my share of my companies’ profits. Dividends therefore act as a control mechanism against corpo- rate hubris and can prevent what Peter Lynch referred to as “diworsification” or growing for growth’s sake, regardless of the total return outcome.17

Market-Based Responses In order to get newer investors interested in stocks, why aren’t there more dividend-centric ex- change-traded funds (ETFs)? Given that a large por- tion of the S&P 500 does not pay a dividend, then the yield on the remainder by default must be higher than the average yield on the S&P 500. Why aren’t there ETFs that invest only in dividend-paying stocks of this index or others? The focus tends to be on large-cap dividend-payers or those that have a long streak of raising their dividends. Perhaps I am miss- ing something, but I have not found research that the length of time a company has raised its dividend has anything to do with the return going forward (versus

selling off a percentage of their portfolio instead of seeking out dividends. Here is why I personally am suspicious of the synthetic dividend approach. For starters, investors who may be unsophisticat- ed find dividends provide a way to generate cash from a portfolio without exerting the effort required to sell securities, not to mention the decision as to when and how much to sell of each security.16

Secondly, a no- or low-dividend policy places an awful lot of trust in the hands of managers. In corporate America, there is a bias against dividends, as managers must put cash to work unless there are not enough available investment opportunities inter-

TABLE 2 Comparison of the Risk-Return Profile of Capital Gains and Total Return

Dividends & S&P 500 Capital Gains Capital Gains: 1/1/1970-12/31/2015 Only: (Total Return)

CAGR 6.97% 10.28%

Standard Deviation 16.58% 17.25%

Sharpe Ratio 0.42 0.6

TABLE 1 Comparison of the Risk-Return Profile of Capital Gains and Dividends (Shown Individually)

S&P Composite Index18

Growth in:

Price Changes Dividends

CAGR (Growth) 6.93% 5.70%

Standard Deviation19 16.39% 6.57%

Sharpe Ratio 0.42 0.87

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(11) Malcom M. Baker et al., “The Effect of Dividends on Con- sumption,” SSRN eLibrary (2007); accessed at: http://ssrn.com/ abstract=886747. Hersh M. Shefrin and Meir Statman, “Explaining Investor Preference for Cash Dividends,” Journal of Financial Eco- nomics 13, No. 2 (1984): 253–282. Hersh M. Shefrin and Richard H. Thaler, “The Behavioral Life-Cycle Hypothesis,” Economic In- quiry 26, No. 4 (1988): 609–643. Richard H. Thaler and Hersh M. Shefrin, “An Economic Theory of Self-Control,” Journal of Political Economy 89, No. 2 (1981): 392–406. (12) “Dividend Irrelevance Theory,” Boundless Finance, May 26, 2016; accessed December 2, 2016, at: www.boundless.com/finance/ textbooks/boundless-finance-textbook/dividends-15/introduction- to-dividends-113/dividend-irrelevance-theory-477-8290/. (13) To be fair to Merton Miller and Franco Modigliani [Merton H. Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of Business 34, No. 4 (1961): 411– 433], they did include the disclaimer that dividends were irrelevant to returns as long as it did not affect corporate decisions. For exam- ple, if a company has 10 independent projects that it could invest in, all exceeding the weighted average cost of capital, corporate in- vestment theory generally says that it should accept all of them, if it could. I’d prefer it invest in the very best three or four projects, pay dividends with the rest of the cash, and let me decide whether to reinvest in the shares or go elsewhere with the money. (14) “Investment Strategies for Non-Dividend Payers,” Ned Davis Group. Data from June 30, 1994, through February 29, 2016. (15) “Compound Annual Growth Rate (Annualized Return) Cal- culator,” MoneyChimp.com; accessed at: www.moneychimp.com/ features/market_cagr.htm. (16) James J. Choi et al., “Saving for Retirement on the Path of Least Resistance,” Rodney White Center for Financial Research-Working Papers, December 1, 2015; accessed at: www.som.yale.edu/faculty/ jjc83/plr_bpf.pdf. (17) Peter Lynch, One Up Wall Street (New York: Simon & Schus- ter, 2nd edition, 2012). Graham (1973), endnote 3: 108–109. (18) Stock market data used in Irrational Exuberance (Princeton, NJ: Princeton University Press, 2000). (19) “Standard Deviation Calculator,” calculator.net; accessed at: www.calculator.net/standard-deviation-calculator.html.

simply a short period of dividend increases). I suspect that this trait just gives investors peace of mind rather than necessarily providing outsized returns. n

Daniel Myers, CFA, CFP, is a full-time instructor of finance at Northeastern State University in Broken Arrow, Oklaho- ma, and serves as director of the Certified Financial Plan- ner® program there. His prior teaching positions include graduate instructor of financial planning at Texas Tech University and Oklahoma City University. He owns and manages a portfolio of eight residential rentals in Okla- homa City and founded King Capital Management, LLC, a registered investment advisor firm specializing in retire- ment planning and investment management from 2000– 2011. He can be reached at [email protected].

(1) “Isaac Newton Quotes,” BrainyQuote.com, 2017; accessed at: www.brainyquote.com/quotes/authors/i/isaac_newton.html. (2) “Yogi Berra Quotable Quotes,” Goodreads.com; accessed at: www. goodreads.com/quotes/261863-it-s-tough-to-make-predictions- especially-about-the-future. (3) Benjamin Graham, The Intelligent Investor (New York: Harper & Row, 1973): 108–109. (4) Robert Hagstrom, The Warren Buffet Way (eBook: Wiley, 2013) 3rd Ed.; accessed at: www.wiley.com/WileyCDA/Section/id-817935.html. (5) Ibid. (6) Lance Roberts, “Dalbar, 2016: Yes, You Still Suck At Investing (Tips For Advisors),” Real Investment Advice, June 6, 2016; accessed at: https://realinvestmentadvice.com/dalbar-2016-yes-you-still-suck- at-investing-tips-for-advisors/. (7) Andrew Bary, “The Best Opportunities in a Half-Century,” Barron’s, December 3, 2011; accessed at: www.barrons.com/articles/ SB50001424052748703922804577066323160174632. (8) Roberts (2016), endnote 6. (9) “Benjamin Graham Quotes,” Quoteswise.com; accessed at: www. quoteswise.com/benjamin-graham-quotes.html. (10) John R. Graham and Alok Kumar, “Do Dividend Clienteles Exist? Evidence on Dividend Preferences of Retail Investors,” Jour- nal of Finance 61, No. 3 (2006): 1305–1336.

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