Photographer: Michael Nagle/Bloomberg

The Hidden Stock Market Price of Falling for the Dividend Ruse

  • Free-money fallacy can end up being costly, study finds
  • Investors tend to use payouts to buy non-dividend stocks

A favorite theory of financial economists is that stock dividends are a mirage, bait conjured by companies to create the illusion of free money. Research from the University of Chicago and Boston College says almost everyone falls for it.

Consider a $100 stock that pays a $10 dividend -- it falls to $90, just as if it paid nothing and the owner sold 10 percent of his shares in the market. Same difference, and yet the study found the allure of the corporate payout incites all kinds of costly behavior among investors.

Mainly, they flock to dividend stocks simultaneously, pushing prices up and expected returns down. During times of low interest rates and poor market performance, when demand for dividends is particularly high, expected returns on dividend stocks are 2 percent to 4 percent below levels in other times, according to the paper.

Source: Samuel Hartzmark and David H. Solomon, “The Dividend Disconnect”

In a yield-strapped environment, investors have a bad habit of viewing dividends as bond coupons that produce stable gains over time, according to Chicago Booth’s Samuel Hartzmark and Boston College Carroll School of Management’s David Solomon. This leads them to focus on stocks’ total return rather than the price performance. As a result, investors hang on to dividend-paying equities for longer than they would have otherwise, the research paper, “The Dividend Disconnect,” finds.

“We wanted to show there is a general misconception about what a stock dividend is,” Hartzmark said by phone. “There is mental trap when investors think about dividends as a separate source of income that’s unrelated to the stock’s capital gains.”

The market’s value-weighted return soars to 16 basis points during days with the highest dividend payouts, four times higher than a mean daily return, the study shows. Most of the dividend money goes to non-dividend stocks, creating predictable price jumps on days of large dividend payouts. In other words, the dividend bounty, a substantial portion of a given stock’s return, often benefits someone other than the stockholder.

The notion that dividends represent extra money investors receive on top of their price return is a mistake made not only by retail investors, but some institutions and mutual funds as well, according to Hartzmark and Solomon.

So far this year, shares of companies with high capital expenditures relative to market value have outperformed those that spend the most on repurchases and dividends by 12 percent, data compiled by Bloomberg show.

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