Thursday, April 4, 2019

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.
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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,
"But this preference isn’t entirely new; it has long been known many investors have a preference for cash dividends. From the perspective of classical financial theory, this behavior is an anomaly. It’s an anomaly because dividend policy should be irrelevant to stock returns, as Merton Miller and Franco Modigliani famously established in their 1961 paper 'Dividend Policy, Growth, and the Valuation of Shares.'"
Swedroe further notes that concentrating on dividend-producing stocks reduces diversification benefits. Concentrating is a key word here because adding some dividend-producing stocks to a portfolio can increase diversification. Said differently, there is nothing wrong with dividend-producing stocks but investing in only those stocks can be hazardous to your portfolio's health. As is often the case, too much of a good thing is too much.

Swedroe concludes that "both theory and historical evidence demonstrate there isn’t anything unique about dividends."

Strategies have been proposed to eliminate sequence of returns risk with high-dividend stocks. This wouldn't have occurred to me because sequence risk is caused by systematically selling stocks when prices are low. Cash dividends don't avoid sales at low prices; they are effectively a forced sale that will occur regardless of the stock's price and with timing decided by the company.

A recent series of three posts at the EarlyRetirementNow blog entitled "The Yield Illusion: How Can a High-Dividend Portfolio Exacerbate Sequence Risk?,"[3] shows that a high dividend yielding portfolio doesn't mitigate sequence risk and can, in fact, exacerbate it.

As always, the bottom line is what a retiree should do with this knowledge. My advising philosophy is that so long as a household understands a strategy and its alternatives, they should do what makes them comfortable.

I once had a client say, "I know I am behaving irrationally but this is what I am most comfortable doing." I don't know how I can argue with that or even if I should. As Michael Finke says, our job as advisors is to make clients happy.

Furthermore, there is no way to prove that even a poor strategy won't turn out well or a good one poorly for an individual household. We can only say what is probably a good or poor bet.

But, if you plan to spend down retirement savings with a strategy based on preferring a dollar of dividends to a dollar of capital gains, you are betting against economic theory, portfolio theory, historical evidence, tax law, behavioral finance and the wisdom of Warren Buffett.

Then again, maybe you will be lucky.


[1] Buffett: You Want a Dividend? Go Make Your Own, Motley Fool.

[2] Vanguard Debunks Dividend Myth, Larry Swedroe.

[3]  The Yield Illusion: How Can a High-Dividend Portfolio Exacerbate Sequence Risk?, EarlyRetirementNow blog.


  1. The spend only dividends strategy is a simple way to generate income, but not spend principal. Many people have a great fear of outliving their retirement funds , and by only spending dividends, they can avoid running out of money...or at least that is their thinking. I agree it is not the best thought out plan...however, I have to say that I have seen it work for a lot of people. I think the biggest drawback is that you tend to underspend in retirement.

    1. When you receive a dividend, you have spent principal. You then have less invested in the stock. You have the same number of shares as before the dividend but they are worth less.

  2. "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. " However, the bond itself is worth 300 dollars less the day after it pays the dividend - just as the stock is.

    1. You're missing the point. On the bond's maturity date it will return the face value's principal. If I buy a $10,000 bond with a maturity date of 1/1/2020, then I will be owed a return of precisely $10,000 principal on precisely 1/1/2020. Stocks provide no such guarantee. I have no idea what the stock will be worth on any future date.

  3. Hmm...maybe you are right academically. but I have questions:
    1. who declares dividend (controlled by company) and what makes price up and down (controlled by market)? does it matter if one don't sell right after dividend distributed? So for company like General Mills (GIS) has hundred year of dividend paying history its value should even be negative already?
    2. do you know Berkshire Hathaway's underlying holdings? Shocked to know Buffett actually loves dividend paying companies, right?
    Just saying

    1. It doesn't matter when you sell. The dividend adjustment happens immediately.

      I don't understand the second part of your first question. Dividends are usually paid from earnings so if General Mills had had no earnings for the past one hundred years then the stock's value would have indeed gone to zero a long time ago. If they had earnings and paid out a small percentage as dividends (they have), their stock price would have grown over time (it has). Why would their stock have become valueless?

      Yes, Buffett loves dividend-paying companies. So do I. Read what the Oracle said. Although he loves investing in dividend-paying stocks he doesn't think BH should pay them. But what he is saying is that you shouldn't care whether or not BH pays dividends because you can create your own dividends with capital gains in a way that is more efficient for both you and BH.

      I love dividend-paying stocks, too, and I invest in them. The point is that there is no reason to prefer dividends over capital gains. If you want to get picky, cap gains can have some tax advantages.

      And, I'm surprised you would think I am unfamiliar with Warren Buffett or Berkshire Hathaway.

      Thanks for writing, jj.

    2. jj, one further comment regarding your "academic" reference. If you read the Swedroe piece that I referenced, you will see that "Moreover, the historical evidence supports this theory—stocks with the same exposure to common factors (such as size, value, momentum and profitability/quality) have the same returns whether they pay a dividend or not."

      The evidence is not only academic. It is also empirical.

  4. I have been guilty of a "dividends/interest only" mindset, and read your post with interest. My intuitive rationale has been that the retained share of stock will generate the dividend (hopefully) in perpetuity, whereas the proceeds from the sale of the share are finite, one-time event.

    Can you help me dispel that notion?

    1. I'll try but I think that's what I argued in the post. Not sure I can improve on that.

      I think the problem is that sometimes our intuition is wrong, at least mine is.

      No dividend is perpetual (see for example, GE).

      With dividends from $100 of a stock, you end up with say 100 shares of stock at $99 versus 99 shares at $100 with cap gains. Your wealth has not changed in either case; it's $9,900. Nor has your share of the company's market cap changed. It's a wash.

      I often prefer capital gains, though I also invest in dividend-yielding stocks, for different reasons. I prefer to sell only when I need the money, not when the company decides I should have some cash. That way, I don't create taxable events to generate cash that I don't want. Also, when I do sell I can perhaps take tax advantage by specifying lots.

      Hope that helps.

      Thanks for writing!

    2. Sorry, I should have said that your wealth is $9,900 worth of stock plus $100 cash in either case.

  5. The one good argument in favor of dividend stocks i've seen is that paying the dividend requires real revenue, and that a consistent history of dividend payments that doesn't destroy the balance sheet is evidence of a company's financial health.

    1. There are a lot of good reasons to buy dividend-yielding stocks. About half of my stock investments are in dividend-yielding (value) stocks and the remainder in growth stocks because their performance is not perfectly correlated. Please do not get the impression from this post that I somehow think there's something wrong with dividend-yielding stocks. The problems stem from investing in them exclusively.

      Also be aware that sometimes stocks with a long history of paying dividends do so right up until the time when they don't, e.g., GE.

      Thanks for writing!

    2. Really? Take a look at CRM and CLF, two funds paying out 20 % dividends. They don't earn near that. They just get the money by selling new stock.

    3. Yes, really. This is a discussion of qualified dividends. "For a mutual fund dividend to be considered qualified, it must be the result of a dividend payment by a stock in the fund's portfolio that meets the holding requirement outlined by the IRS."

      A mutual fund dividend generated from capital gains or any other method is not "qualified" for a tax preference. It will be reported to the IRS as non-qualified ordinary income.

  6. BTW, please also follow me on Twitter as @Retirement_Cafe. This dividends post received kudos on Twitter from Kirstan's blog can be technically challenging but it's brilliant. Also received an "Editor's Choice" at and a retweet from The University of Chicago Booth School of Business.

    I post a lot of links to great columns from other writers on my Twitter account that I can't always work into a post at Retirement Cafe.

  7. Dirk, thanks for the thoughtful post. There's one thing I don't understand: doesn't _some_ dividend preference still make some sense if you hold healthy companies during downturns but want cash distributions every year?

    I completely understand the theoretical point that it's the value that counts, and eliminating non-dividend stocks increases your risk.

    But if you're a Buffett-style value investor _and_ you either need or want some cash every year, wouldn't you rather avoid being forced to sell stocks during a downturn -- when you may believe they are irrationally undervalued (something Buffett would often say during a downturn)?

    I've long wanted to ask about this on my blog so I'm happy for the opportunity to raise this question.

    1. These are two different questions.

      If you want cash distrubutions each year then that isn't a problem whether you receive dividends or sell stock. It's when you don't want a distribution that you generate a taxable event unnecessarily with a dividend. You can decide when to sell stock; the company decides when to pay a dividend. But that isn't a "dividend preference."

      Dividend preference is when you think receiving a dividend is somehow different than selling the same dollar value of stock. That's the irrational belief that behavioral finance people study.

      Regarding forced sale of stock in a downturn, a dividend will do that. A stock sale won't. You simply don't sell in the latter case.

      With a dividend, the company will decide, regardless of bull or bear market, to pay you cash whether or not you want it instead of reinvesting that cash in the company, as a growth stock would do.

      I'll say again. There's nothing wrong with dividend-yielding stocks. Half of my portfolio is invested in them. The risk occurs when you invest in nothing else.

      Thanks for writing!

    2. I have my dividend stocks in a DRIP... how come you aren't factoring that in your reply? In a market downturn, my dividends get to buy more shares and compound themselves.

    3. Sure, you can reinvest the dividends at the new current stock price. But with a growth stock, you avoid receiving a dividend and possibly paying taxes by simply leaving the amount of the dividend invested in the stock. The point isn't that one is better than the other. The point is they're the same.

      Thanks for writing!

  8. Lets take a scenario:
    In Case 1: You have 100$ of stock that pays 2.5$ dividend. And in Case 2: you have 100$ stock that does not pay any dividend.

    Now lets assume you have fixed expenses of 2.5$. In a negative scenario where there is market panic and we see a crash in the price by 50%. In case 1, you would still get 2.5$ from the company, while in case 2 you would have to sell 2.5$ worth of stock. Now lets say market comes back to its senses and the stock in Case 2 doubles back. You would be sitting on 95$ worth of stock. There is permanent value lost in case 2. Dividend paying stock allows you to stay the course in rough weather. Especially if you count on it for expenses.

    1. In case 1, you receive a $2.50 dividend and the stock price is immediately lowered (by a stock specialist at the exchange) by the amount of the dividend leaving you with $97.50 worth of stock and a $2.50 cash dividend.

      In case 2, you sell $2.50 worth of stock and are left with $97.50 worth of stock and $2.50 cash. There is no difference.

      You can then lower either amount by 50% and the double it and they're still identical.

      The point you are missing is that the stock price is lowered by the exchange immediately following the dividend payment.

      There is no reason to prefer the dividend scenario.

  9. Hi Dirk. What about mutual funds that pay high dividends like vanguard Wellesley income fund?

    1. I don't understand your question. Mutual fund dividends are seldom all qualified dividends. Some are capital gains distributions. Does that answer your question?

  10. I started taking dividends in cash vs reinvesting them when my spouse and I both retired. The dividends are from a portfolio bought long ago with little dividend preference. My reason for doing this is I will be taxed on the dividend whether it is reinvested or used as cash flow. Hence why not use the dividend first as cash flow.

  11. Isn't the value of a stock determined each day through trading? If there are more buyers than sellers, the price will trend up generally, with indifference to whether the company paid a dividend or used its cash some other way.

    1. Yes, of course. And the price adjustment due to a dividend payment will generally be lost in that daily trading volatility, such that the price may end up higher or lower, as any other day. (An exception is the unusual $3 dividend once paid by Microsoft when the amount was not lost in daily trading noise and ended up down something like $2.95.)

      The exception is immediately post-dividend, when the specialist at the exchange will adjust the price by the amount of the dividend and then the auction will continue (see How Does the Stock Price Change When a Dividend Is Paid?, for example).

      Will the market send the stock price right back to its pre-dividend level? It's possible but equally possible that it will not. Whether the stock will ultimately go up or down that day after the adjustment is unpredictable. Research shows that trading strategies based on dividend payment dates are unsuccessful.

      Thanks for writing.

  12. I have been Referred to you by an Dale Roberts article in Seeking Alpha.
    I'm 72 and have had enough capital to use my dividends for income and also some go into auto reinvestment. However, the basis of what you say based upon my experience, is "somewhat true".

    Today this is what I've learned and changes I've made.
    1. Even with a large capital base you cannot deny inflation thus the dividends over much time buy less. IF you have to begin selling shares of a capital gains type portfolio to survive you become a cat eating its tail.
    2. I would advise other dividend investors to use ETF index funds to BLEND their portfolio with some income producers like BIZD "AND" hold growth stocks using an index ETF that will grow capital similarly to owning SPY, or the 500. FDVV or RDIV pay the holder a MM equivalent dividend income, AND grow in capital value with the market. These ETF's when graphed compare to SPY offering capital appreciation, albeit at a slightly lessor rate. A very small compromise to not run out of money in retirement.
    3. An investor who follows Warren into a 2008 downturn is fine if he is 35 with plenty of time before retirement, because he's sitting on his portfolio. However, if retired you sell your capital appreciation stocks to pay bills. Thus, most folks who are retired face this cash flow problem. In fact if you like to do research you'll find as in the article I read in 1985 the folks who had stock portfolios throughout much of the 1970's saw the market for 8 years go up and down and in essence nowhere. They lost a huge portion of their capital to pay bills. Thus there is a place for dividends in a retirement portfolio to buffer down market periods and allow the investor to RIDE IT OUT without having to sell their stocks to pay bills.

    Also, I've tried everything since 1983, and owning an individual stock portfolio is something even Mutual Fund Manager's have proven it's difficult to outperform the Index 500. Mutual Funds often under-perform with guessing errors and are too expensive with high fees. They kill you with taxes on YE capital gains distributions. Index funds only produce capital gains when you sell.

    Wish I began the blended portfolio 20 years ago.
    Best Regards, Sam Oughton