Larry Swedroe, ETF.com, September 18, 2017
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.”
"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. Yet many investors ignore this information and express a preference for dividend-paying stocks.
One frequently expressed explanation for this preference is that dividends offer a safe hedge against the large fluctuations in price that stocks experience. But this ignores the fact that when a dividend is paid, the stock’s value is offset by an equal fall in the stock’s price. It’s what can be called the fallacy of the free dividend—the only free lunch in investing is diversification, not dividends." (emphasis mine)
Todd Schlanger and Savas Kesidis from Vanguard’s research team contribute to the literature on dividends through their study, “An Analysis of Dividend-Oriented Equity Strategies.”
A similar effect takes place in the options world, where new traders and investors are often lured into the idea of "income trading", often marketed under the catchy theme of "consistent monthly income". There is no such thing, as this type of approach is often done with a strategy of selling far out of the money options that have a high win rate, but also high tail risk. In order to generate sufficient "income", a large number of contracts must be sold creating large notional risk. New traders can go for long periods of time without the tail risk showing up, creating overconfidence. Eventually a large sustained price move produces a rude awakening.
As we explain many times, options trading is not income. Unlike dividends, the fact that you get cash into your account does not mean the cash will necessarily stay there. You might need to buy those options back for more than you paid. It would not prudent to rely on that cash for your income.
Conclusion
Be careful about tilting your portfolio too heavily towards an approach that relies on income generation. Not only is this tax inefficient, but it reduces diversification and can create hidden tail risks. For traders and investors who need regular withdrawals from their portfolio, a diversified total return approach is often going to produce better after-tax long term outcomes.
Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008, and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University.
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