Money and Happiness | Why Dividends Are Not Free Money

Whenever I write about investing in the stock market, readers criticize me – with good reason – for not having addressed the question of dividends.

“I invested in pharmaceuticals with the payment of dividends,” a reader told me recently. I reinvested them for several years, which was very interesting. »

Another reader writes, “Investing in dividend stocks is an approach you don’t hear much about. I would like your opinion on this investment strategy. »

To be honest, I have already been seduced by dividends because they seemed magical to me.

Basically, dividends are the part of the profits that a company can choose to pay out in cash to its shareholders four times a year generally.

For an investor, this money seems to fall from the sky: one day, you had a few dollars on hand in your brokerage account; the next day you have hundreds, even thousands. It’s kind of like payday for investors.

Seeing these dollars appear without having sold your investments seems to be proof that you have made the right asset choices.

However, at the risk of displeasing, I am not a big fan of dividends.

First, let’s bust a myth: Dividends aren’t free money.

Few people realize that a company that pays $1 in dividends sees its stock price decline by an average of $1 before the dividend is paid, according to a study⁠1 by David H. Solomon and Samuel M. Hartzmark, the Boston College Carroll School of Management.

This study also shows that investors rarely use the dividend to reinvest it in the same company, but rather to make different transactions on the stock market. However, since the number of transactions is almost always inversely proportional to the returns, this “bad” behavior is encouraged by the payment of dividends.

Eventually, investors tend to rush into dividend-paying stocks when interest rates are low, which inflates their stock market value and “causes lower dividend-paying stock yields” in the long run, the researchers write.

Marc-André Turcot, portfolio manager at Demos gestion de patrimoine familial (Raymond James) and lecturer at the University of Sherbrooke, notes that investors are often drawn to the “tangible” side of dividends.

“A lot of people have a great fear of using their capital, so in that context the dividend is seen as a form of income that you get without having to sell your stock,” he says.

He explains that at the end of the day, whether the dollar comes from a dividend or from the sale of a stock, it is the same dollar.

Mr. Turcot notes that one of the advantages of the dividend for some investors is that it is treated differently for tax purposes.

An advantage that disappears when it comes to a dividend paid by an American company. “People tend to forget that, so you have to be careful. »

It also happens that companies borrow money in order to pay a dividend. “People see an 8% dividend and say, ‘Wow!’, but that doesn’t necessarily mean the company paying it is in great financial shape. »

On the other hand, companies that are doing very well may not pay a dividend. This is the case of Berkshire Hathaway, the conglomerate led by Warren Buffett.

The businessman and investor prefers to use his profits to acquire other companies, among others. “But if the time comes – and there will come a day – when we don’t think we can create more than $1 of market value per dollar retained, then a dividend should be paid,” he said at the annual meeting of its shareholders of… 2008.

Fifteen years later, Berkshire Hathaway still isn’t paying a dividend.

Warren Buffett suggests to his shareholders who want an income to sell part of their shares to finance their lifestyle. But many don’t want to because it erodes their asset… an asset that is worth more today because Buffett doesn’t pay a dividend.

The reasoning quickly becomes circular.

Performance-wise, what about? In general, Canadian companies that pay a large dividend have not done better than the others.

For example, $10,000 invested in the Vanguard Canadian High Dividend Index ETF (VDY) fund in 2013 was worth about $23,500 at the start of 2022, including the reinvestment of dividends. The same amount invested in Canada’s largest companies in the iShares S fund

Since 2022, high-dividend funds have been popular, and have performed slightly better (0.56% per year) than the broader market. The future will tell us if this outperformance will continue, or if the reversion to the mean will take place.

I do not deny that there are success stories with dividends. A patient investor who has invested for years in a company that pays a dividend (National Bank, for example) has experienced a high return. It’s always tricky to argue with success, but I would argue that investing in a company is much more risky than buying the entire market, through an exchange-traded fund (ETF). And an investor who would have chosen another major bank (CIBC, for example) would have had a lower return, and therefore a completely different experience with dividends.

If you own ETFs or mutual funds, you are likely to receive a dividend, since your fund contains stocks of companies that pay dividends. Several brokerage platforms offer to reinvest it automatically and free of charge in units of the same fund, an option that I have personally chosen in all of my accounts (TFSA, RRSP, RESP, etc.).

That said, I’m not completely against dividend strategies. For example, if receiving dividends can psychologically help you to be patient and not sell your investments during a stock market crash, then they will have done important work.

No one should invest with the goal of being the richest person in the graveyard. The idea is to find the investment method that suits us and that we can follow – ideally for decades.

Last week, I invited you to share your biggest lessons in investing. Here are some of the responses received:

Marcel writes, “What I’ve learned with investing is that the more you touch them, the worse they go, considering human nature, my tendency to want to control everything and my fear of losing… From experience, I have realized that my returns were better when someone advised me than when I tried to manage everything alone, despite the fees paid to my advisor. »

Katherine writes, “One of the best investment tips is to invest a little each week, or consistently with direct debits. You just have to pay yourself first. We start with a small amount and increase over time. Once a habit is created, it is difficult to break it. »

Marc-André writes: “My lesson: Keep It Simple, Stupid. I started investing in 2020 and initially thought I saw golden opportunities everywhere I looked. Crypto, cannabis, energy, etc. My dreams quickly fell to terra firma, and my ego took a hit… I wasn’t the next Warren Buffett, after all… But the “real” Warren taught me one thing : buy index funds and move on. Keeping it simple, investing for the long term and not being driven by emotions were my biggest lessons. »