The Dividend Disconnect
60 Pages Posted: 29 Nov 2016 Last revised: 18 May 2017
Date Written: March 9, 2017
We show that many individual investors, mutual funds and institutions trade as if dividends and capital gains are separate disconnected attributes, not fully appreciating that dividends come at the expense of price decreases. Behavioral trading patterns (e.g. the disposition effect) are driven by price changes excluding dividends. Investors treat dividends as a separate stable income stream, holding high dividend-yield stocks longer and displaying less sensitivity to their price changes. We term this mistake the free dividends fallacy. Demand for dividends is systematically higher in periods of low interest rates and poor market performance, leading to high valuations and lower future returns for dividend-paying stocks. Investors rarely reinvest dividends into the stocks from which they came, instead purchasing other stocks. This creates predictable marketwide price increases on days of large aggregate dividend payouts, concentrated in stocks not paying dividends.
Keywords: Behavioral Finance, Dividends, Mental Accounting, Asset Pricing
JEL Classification: G02, G11, G12, D14
Suggested Citation: Suggested Citation