This post also appears at Forbes.com. Reprinted with permission.
One of the most common misperceptions in investing concerns dividends and interest income. We’ve all heard the old adage: spend investment income (dividends & interest) and leave principal alone (capital gains). It sounds right. And a study published by three finance professors from Harvard, Stanford, and New York University confirms investors actually behave this way (The Effect of Dividends on Consumption). They’re primary finding was that:
“…consumption indeed responds much more strongly to returns in the form of dividends than to returns in the form of capital gains.”
So why do we have a greater propensity to spend dividends and hold onto capital gains? This study claims it is subconscious mental accounting, whereby investors view dividends and capital gains in two completely separate buckets. In other words, dividends and interest are perceived as a more “permanent” form of income, and can therefore be consumed without really impacting total wealth. Capital gains, on the other hand, are not permanent. So withdrawing and consuming them will have a greater negative wealth effect.
It seems obvious, then, why investors would gravitate toward income producing assets: higher yields mean they can spend more, and their principal remains “safe.” This often leads to a belief that higher yielding securities are better, particularly in retirement. But is this perception accurate? From a pure economic standpoint, the answer is no.
Dividends & Interest
Let’s first clear up the commonly misunderstood dividend. Paying a dividend is simply one option a company has to distribute earnings. The amounts can and do change. More importantly, the value of ownership in a stock declinesafter receiving a dividend. Let’s assume you own one share of a hypothetical company: High Yield Corporation. The stock is currently worth $50, and the company pays a $5 dividend. After receiving the dividend, the price of your share would be around $45. Your principal falls, but now you have $5 in qualified income if the stock was held outside of a retirement account.
The impact to total wealth is exactly the same as if the stock appreciated from $45 to $50 and the investor sold $5 worth of stock (clearly you can’t sell partial shares of stock; this is for illustrative purposes only). You’d still end up with $5 in cash and $45 worth of stock.
Of course, interest income is different. Theoretically your principal would not deteriorate if you purchase a bond and hold it until maturity, ignoring inflation. But investors need to be careful with fixed income. The perception that bonds are “safe” is entirely relative. If you’re referring to a US Treasury, then yes, you can assume a very low likelihood of default. But the same can’t be said for debt of other nations, or other forms of fixed income like corporate bonds. More on this later.
How does this misperception hurt investors?
It’s simple: it leads to less diversified portfolios.
In an attempt to generate more income, many investors build portfolios concentrated in high yield stocks. But there is no guarantee high yield stocks will outperform their lower yielding counterparts over the long-term. This can even lead to unintentional economic sector bets. Telecommunications and utilities, for instance, tend to have a greater number of dividend paying companies. These sectors also happen to act very defensively—at least historically speaking. So while you’d likely be better positioned for down markets, you could miss significant upside returns during bull markets. As such, it is wise to own a diversified mix of both.
The pursuit of higher yields in the fixed income world poses an entirely different risk than stocks. Bond investors are typically compensated for risk through higher yields. This could be for default risk, interest rate risk, and/or inflation risk, to name a few. But regardless of the reason, higher yielding bonds typically carry higher risk. So investors looking to increase their level of interest income could unintentionally increase their portfolio’s risk profile. Moreover, investors need to be wary of taxes. Stock dividends and capital gains are currently taxed at the same rate. Not true for bonds. Interest is taxed as ordinary income, so increasing your portfolio’s yield could also increase your tax bill.
So what do we know? Many investors prefer higher yielding securities so they can “live off the interest.” But this is primarily a psychological bias rooted in arbitrary mental accounting practices. In reality, capital gains provide the exact same economic benefit as dividends and interest income. High yield securities are not inherently better, so investors should make sure their exposure is part of a larger diversified portfolio.
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