The Dividend Disconnect

• DOI: http://doi.org/10.1111/jofi.12785
• Published date: 01 October 2019
• Date: 01 October 2019
• Author: SAMUEL M. HARTZMARK,DAVID H. SOLOMON

THE JOURNAL OF FINANCE •VOL. LXXIV, NO. 5 •OCTOBER 2019

The Dividend Disconnect

SAMUEL M. HARTZMARK and DAVID H. SOLOMON∗

ABSTRACT

Many individual investors, mutual funds, and institutions trade as if dividends and

capital gains are disconnected attributes, not fully appreciating that dividends re-

sult in price decreases. Behavioral trading patterns (e.g., the disposition effect) are

driven by price changes instead of total returns. Investors rarely reinvest dividends,

and trade as if dividends are a separate, stable income stream. Analysts fail to ac-

count for the effect of dividends on price, leading to optimistic price forecasts for

dividend-paying stocks. Demand for dividends is systematically higher in periods of

low interest rates and poor market performance, leading to lower returns for dividend-

paying stocks.

The humble dividend is reclaiming its rightful place as the arbiter of

stock-market value . . . To investors desperate for income, the argument

for buying equities is, well, duh. Who wouldn’t want a higher income?

Shares might swing around, but corporate managers go out of their way

to preserve the dividend.

—James MacKintosh, The Wall Street Journal, May 9, 2016

AT THE HEART OF THE DIVIDEND irrelevance, result from Miller and Modigliani

(1961) is the idea that money is fungible, which implies that a value-maximizing

investor should treat money equally regardless of its source. Because of this,

∗Samuel M. Hartzmark is at Chicago Booth School of Business, University of Chicago. David

H. Solomon is at Carroll School of Management, Boston College. The authors are grateful to

Malcolm Baker, Randy Cohen, Kent Daniel, Andrea Frazzini, Thomas Gilbert, Raife Giovinazzo,

Pete Hecht, Zoran Ivkovich, Markku Kaustia, Owen Lamont, Christoph Merkle, Francisco Santos,

Hersh Shefrin, Kelly Shue, Eric So, Meir Statman, Paul Tetlock, Jack Vogel, and seminar par-

ticipants at Arizona State University, Australian National University, the University of Florida,

the University of Miami, Chicago Booth School of Business, UC Irvine, Fuller & Thaler Asset

Management, Cubist Systematic Strategies, SEC, Massachusetts Institute of Technology, Tilburg

University,Erasumus University, Maastricht University, Southern Methodist University, the Uni-

versity of Sydney, the University of Technology, Sydney, the MSUFCU Conference on Financial

Institutions and Investments, European Finance Association Conference, American Economic As-

sociation Conference, the Q-Group, Red Rock Finance Conference, the UC Davis GSM Behavioral

Finance Conference, the Miami Behavioral Finance Conference, the Colorado Finance Summit,

WU Gutmann Center Symposium, UT Smokey Mountain Finance Conference, University of Ken-

tucky Finance Conference, Brandes Institute Meeting, and the NBER Behavioral Finance Meeting

for helpful suggestions. The authors thank Terry Odean for providing the data on individual in-

vestors. The authors have nothing to disclose with respect to the Journal of Finance’s submission

guidelines and policies and conflict of interest disclosure policy.

DOI: 10.1111/jofi.12785

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academic finance typically assumes that an investor in a frictionless world is

indifferent between receiving $1 of dividends (with the price declining by $1)

and selling $1 of that position. Adding real-world frictions such as taxes and

trading costs to the model can influence whether an investor prefers to receive

a dividend or sell a given amount of stock. However, even with these frictions,

investors are assumed to simply maximize the value of their position after

subtracting costs, and otherwise treat the two sources of profits equally. This

assumption (implicitly) underlies the vast majority of asset pricing research,

as it justifies why a return that combines capital gains and dividends is the

central variable of analysis.

Although the idea in Miller and Modigliani (1961) is intuitive when explicitly

laid out, some of its implications (e.g., the price declining to offset the dividend

payment) may not be salient to many investors. Dividend irrelevance runs

counter to intuition from other areas of life, where harvesting the fruit from

a tree is viewed as fundamentally different than harvesting the tree itself.

One often reads statements like the quote with which we began, which at first

glance may seem reasonable, but upon reflection are difficult to reconcile with

the Miller and Modigliani (1961) framework.

To value a stock for its income stream, like our initial quote claims, may

speak to a sophisticated understanding of taxes and transaction costs, but the

phrase “duh” does not immediately suggest such nuance. The last sentence of

the quote implies that dividends are viewed as a safe hedge against uncertain

fluctuations in price, ignoring the fact that dividends come directly at the

expense of the price level. We term this mistake the free dividends fallacy—

unless the trade-off between price changes and dividends is salient, dividends

are apt to appear as a desirable, free source of income. We examine whether

evidence of such a mistake is present in the trading and pricing of securities.

We find that the disconnect between price changes and dividends appears to be

of considerable practical importance, affecting outcomes as varied as trading

related to gains and losses, prices of dividend-paying stocks, analyst forecasts,

and dividend reinvestment.

We begin by presenting evidence that investors track price changes and div-

idends separately, rather than combine them into returns. This behavior is

consistent with investors using separate mental accounts (Thaler (1980,1999),

Frydman, Hartzmark, and Solomon (2017)) for price changes and dividends,

an idea first proposed by Shefrin and Statman (1984). If investors track each

variable separately, price changes are likely to be more salient as a measure

of stock performance, as prices have larger and more frequent moves than

dividends. We examine various trading behaviors where the decision to sell

an asset is based on some function of past stock performance, and show that

trading is driven primarily by past price changes rather than past returns. In

particular, we examine the disposition effect (the tendency to sell winners more

often than losers, as in Shefrin and Statman (1985)), the rank effect (the ten-

dency to sell extreme-ranked positions, as in Hartzmark (2015)), and the rolled

disposition effect (the tendency to sell a new position once its value exceeds the

initial investment in a previously sold position, as in Frydman, Hartzmark,

The Dividend Disconnect 2155

and Solomon (2017)). Each of these behaviors is a response to a different as-

pect of past stock performance (e.g., performance relative to purchase price, or

performance relative to other holdings in a portfolio), so together they provide

a sense of how investors consider “performance.” Given that these patterns are

behavioral, the economic content of dividends, such as taxes or signaling, is

unlikely to account for the results.

To assess these effects, we decompose the drivers of performance into a price

change component and a dividend component. In each case, we find signifi-

cantly less selling response to the dividend component, and in a number of

cases dividends do not appear to be part of the performance evaluation at

all. First, when examining the disposition effect, we find that for individual

investors, mutual funds, and institutions, the perception of gains and losses

seems to be driven largely by price changes, without regard to the effect of

dividends on the price. Next, when examining sales of extreme-ranked po-

sitions, we find that each investor type increases their selling propensity in

response to stock rankings based on price changes, but shows little response

to ranks that include dividends. When we compute the combined gain and

loss on a reinvested position, individual investors (for whom the data allow

us to examine this question) trade as if the gain/loss status does not include

dividends.

By evaluating stock performance in this manner, investors do not appear to

correct for the impact of dividends on the price level. To see this, consider two

stocks that increased in price from $5 to $6, but one of them first rose to $7

then paid dividends of $1. Investors who focus only on price changes treat the

two stocks as having equivalent performance. Importantly, however, the fact

that investors appear to give dividends less weight when trading based on past

performance does not mean that dividends are ignored in the decision-making

process. Rather, if price changes and dividends are viewed as disconnected

attributes, investors who focus on dividends separately will view the $1 as a

small positive gain distinct from the price level. Such an investor will thus suf-

fer from the free dividends fallacy, as dividends appear to be a small consistent

gain with no apparent offsetting cost in price.

Investors focusing on dividends, presumably for the perceived attractiveness

of the income stream, are likely to pay less attention to the capital gains compo-

nent of returns. Consistent with this view, we show that investors (individuals,

mutual funds, and institutions) are less likely to sell stocks that pay more divi-

dends. Dividends also make investors less sensitive to past price changes when

selling stocks. This result supports the prediction that investors do not view

dividends and capital gains as part of a combined returns measure, but rather

focus on one variable or the other.

If investors view dividend payments as separate from the value of their po-

sition, they may not reinvest dividends into the stocks from which they came.

Baker, Nagel, and Wurgler (2007) show this for individual investors, arguing

that dividends are used to finance consumption. We document that dividend

reinvestment is also rare among mutual funds and institutions, even though