"Investors should be indifferent to $1 in the form of a dividend (causing the stock’s price to drop by $1) or $1 received by selling shares. This must be true, unless you believe that $1 is not worth $1. This theorem has not been challenged since—except by those bitten by the “dividend bug.”
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 May 2017 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. Jesse maintains the LC Diversified Forum, as well as contributes to the Steady Condors newsletter.
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Recent Articles
Articles
Pricing Models and Volatility Problems
Most traders are aware of the volatility-related problem with the best-known option pricing model, Black-Scholes. The assumption under this model is that volatility remains constant over the entire remaining life of the option.
By Michael C. Thomsett, August 16
- Added byMichael C. Thomsett
- August 16
Option Arbitrage Risks
Options traders dealing in arbitrage might not appreciate the forms of risk they face. The typical arbitrage position is found in synthetic long or short stock. In these positions, the combined options act exactly like the underlying. This creates the arbitrage.
By Michael C. Thomsett, August 7
- Added byMichael C. Thomsett
- August 7
Why Haven't You Started Investing Yet?
You are probably aware that investment opportunities are great for building wealth. Whether you opt for stocks and shares, precious metals, forex trading, or something else besides, you could afford yourself financial freedom. But if you haven't dipped your toes into the world of investing yet, we have to ask ourselves why.
By Kim, August 7
- Added byKim
- August 7
Historical Drawdowns for Global Equity Portfolios
Globally diversified equity portfolios typically hold thousands of stocks across dozens of countries. This degree of diversification minimizes the risk of a single company, country, or sector. Because of this diversification, investors should be cautious about confusing temporary declines with permanent loss of capital like with single stocks.
By Jesse, August 6
- Added byJesse
- August 6
Types of Volatility
Are most options traders aware of five different types of volatility? Probably not. Most only deal with two types, historical and implied. All five types (historical, implied, future, forecast and seasonal), deserve some explanation and study.
By Michael C. Thomsett, August 1
- Added byMichael C. Thomsett
- August 1
The Performance Gap Between Large Growth and Small Value Stocks
Academic research suggests there are differences in expected returns among stocks over the long-term. Small companies with low fundamental valuations (Small Cap Value) have higher expected returns than big companies with high valuations (Large Cap Growth).
By Jesse, July 21
- Added byJesse
- July 21
How New Traders Can Use Trade Psychology To Succeed
People have been trying to figure out just what makes humans tick for hundreds of years. In some respects, we’ve come a long way, in others, we’ve barely scratched the surface. Like it or not, many industries take advantage of this knowledge to influence our behaviour and buying patterns.
- Added byKim
- July 21
A Reliable Reversal Signal
Options traders struggle constantly with the quest for reliable
By Michael C. Thomsett, July 20
- Added byMichael C. Thomsett
- July 20
Premium at Risk
Should options traders consider “premium at risk” when entering strategies? Most traders focus on calculated maximum profit or loss and breakeven price levels. But inefficiencies in option behavior, especially when close to expiration, make these basic calculations limited in value, and at times misleading.
By Michael C. Thomsett, July 13
- Added byMichael C. Thomsett
- July 13
Diversified Leveraged Anchor Performance
In our continued efforts to improve the Anchor strategy, in April of this year we began tracking a Diversified Leveraged Anchor strategy, under the theory that, over time, a diversified portfolio performs better than an undiversified portfolio in numerous metrics. Not only does overall performance tend to increase, but volatility and drawdowns tend to decrease:
Monday, September 30, 2019