EC 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. [Tweet this]

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,

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Doug Mortensen 1 year ago Member's comment

Various sources have indicated that dividends account for 42 percent of the long-term performance of the S&P 500. Based on that, I would expect a dividend-only strategy would get you a little less than half the total return. Of course, that assumes an investment in the broad market. The dividend portfolio used may have been skewed toward higher-yield, lower-growth choices.

Dick Kaplan 1 year ago Member's comment

Very interesting. Dirk Cotton, what are your thoughts on the above?