As investors, we are exposed to biases, including the dividend bias.
Richard Feynman once said that the first principle is that you must not fool yourself and you are the easiest person to fool. Most of us have an inner voice that always says a good outcome is a result of smartness, and a bad outcome is due to bad luck.
In the stock market, it’s easy to fool yourself. Decision-making is all about making good or bad outcomes. We all fall prone to what Annie Duke calls resulting: we judge the quality of our decisions on the outcome, not the other way around. But you can have a good outcome despite a bad decision, and you can have a bad outcome even though the quality of your decision was good.
The same goes for dividend investing. We get lured by receiving tangible payments, and we forget the opportunity cost of the capital distribution. Warren Buffett has never walked into his office just to focus his investments on one asset class or one style of investment. Why should he limit himself? It doesn’t make much sense to potentially exclude many suitable investments. Dividend investors get obsessed with “income” and ignore the many other viable options.
As a small private investor, you obviously don’t have the time or the knowledge Buffett has. If that’s the case, you are most likely better off to invest in ETFs and/or mutual funds. However, many small investors gravitate toward dividend stocks. The interest has further increased with the low interest rates and “flight” away from bonds. Many dividend investors consider the dividend a substitute for the low coupons.
Why is that?
We suspect it’s the lure of the “income”. It feels great to receive a dividend, as most people either ignore or forget that all dividends have an opportunity cost. Thus, many investors have a dividend bias.
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Why do we make bad decisions?
We think we know more than we do, ignore relevant information, seek confirmations from others, don’t acknowledge being wrong, and have an aversion to losses. These are called cognitive biases:
What is a cognitive bias?
Cognitive errors, that are a result of cognitive biases, have got a lot of attention over the last two decades. It’s a pretty new field in the world of science, and new biases are added every year.
Rolf Dobelli gives a good description of what cognitive errors are in The Art of Thinking Clearly:
The failure to think clearly, or what experts call a “cognitive error”, is a systematic deviation from logic – from optimal, rational, reasonable thought and behaviour. By “systematic” I mean that these are not just occasional errors in judgement, but rather routine mistakes, barriers to logic we stumble over time and again, repeating patterns through generations and through the centuries. For example, it is much more common that we overestimate our knowledge than that we underestimate it. Similarly, the danger of losing something stimulates us much more than the prospect of making a similar gain. In the presence of other people we tend to adjust our behaviour to theirs, not the opposite. Anecdotes make us overlook the statistical distribution (base rate) behind it, not the other way around.
Put short, cognitive errors are biases that distort our thinking and lead to wrong conclusions or non-optimal behavior. The most typical biases you face as a trader or investor are these:
- Confirmation bias
- Survivorship bias
- Risk aversion
- Availability bias
- Recency bias
- Clustering illusion
- Endowment effect
- Gambler’s fallacy
- Omission bias
- Lumpy rewards vs. even distributions
There are, of course, many more. One bias that has never been made into any list is the dividend bias:
What is the dividend bias?
The dividend bias is a cognitive error just like all the other cognitive biases mentioned above. The dividend makes you prone to only invest in dividend-paying stocks. Furthermore, you become “blind” to the opportunity cost and alternatives.
Many good stocks could pay a dividend but chose not to. Moreover, you are likely to gravitate toward high-yield stocks, even though history tells us this segment has performed worst among the dividend stocks.
Why do we form biases?
Daniel Kahneman wrote about System 1 and System 2 in Thinking, Fast And Slow. System 1 is fast and intuitive thinking, while System 2 is slow, analytical, and rational thinking. Kahneman wrote:
System 1 operates automatically and quickly, with little or no effort and no sense of voluntary control.
System 2 allocates attention to the effortful mental activities that demand it, including complex computations. The operations of System 2 are often associated with the subjective experience of agency, choice and concentration.
Kahneman argues humans are more inclined to use System 1 because that saved us from predators on the savanna. When the danger is immediate, you have no time to sit down and think. We react by intuition. Obviously, this thinking doesn’t do you any good when you invest for the future. But System 1 interferes because it’s running on autopilot.
What is the opportunity cost?
Charlie and I don’t know our cost of capital. It’s taught in business schools, but we’re skeptical. We just look to do the most intelligent thing we can with the capital that we have. We measure everything against our alternatives. I’ve never seen a cost of capital calculation that made sense to me. Have you Charlie?
– Warren Buffett
The opportunity cost is the same as the alternative cost. This “cost” is the difference between the best use of your capital and the next best, etc. Why would you invest in your inferior investment ideas compared to the best one? Your best investments should put the bar as high as possible for your other investments. Diversification might, of course, be part of the evaluation because most of us are not as intelligent and wise as Warren Buffett.
For example, what is the opportunity cost of Charlie Munger’s, Buffet’s business partner? That is his investments in Berkshire and Costco (at the right price).
Companies have an opportunity cost as well. Many companies could pay a dividend but choose not to. Why do they do this? Mainly because they believe the capital is better spent elsewhere.
A company can reinvest in the existing business, it could diversify into new businesses, it could buy back shares, or it could reduce the debt. When you invest in a stock because of its quarterly dividend, it comes with an opportunity cost. Moreover, it leaves the compounding to you.
Dividend stock can be a useful heuristic
Heuristics is a way of thinking that is pretty close to System 1 described above. A heuristic way of investing is more like a practical method to generalize and to make “shortcuts”. This saves time and effort. It’s not optimal, but given time and knowledge constraints, it might be a viable option for many investors.
Other names for heuristics are:
- Rule of thumb.
- Educated guess.
- Even trial and error can be labeled heuristics.
We are not suggesting dividend investors are fools or superficial investors. However, we believe many investors use dividend stocks as heuristics to make decisions efficiently and quickly.
We can argue it can serve as a useful heuristic because we know two facts based on empirical evidence:
- Dividend-paying stocks have outperformed non-payers for over 100 years.
- The best dividend stocks have not been the 20% lowest yielders nor the 20% highest yielders. The best have been in the middle.
Based on these two simple criteria, you can narrow down your stock universe substantially. But you must ask yourself this: Is this a smart heuristic? It could be, but many invest in the wrong segment, namely the high-yield segment:
Stay away from high yield stocks
Many advisors and newsletters claim to weed out the good and bad stocks among the high yielders. The purpose is, of course, to attract clients who want “income”. We believe these investors sooner or later wake up to a nasty surprise. There is a ton of evidence indicating the 20% highest yielders have been, over time, the worst-performing quintile of the dividend payers. You find the best dividend stocks among the average or median yielders.
Dividend bias – stay within your circle of competence
Warren Buffett once said that you must always invest within your “circle of competence”. The biggest risk you can take is investing in companies or strategies you don’t fully understand.
By investing in dividend stocks, you might stay within your circle of competence. Moreover, most dividend stocks have had a “proven” business model for years. Thus, ensure you are an intelligent dividend investor and don’t only invest in getting a dividend. No investor gets richer by receiving a dividend. A dividend is a transfer from the company’s account to your investment account (often less taxes). Don’t let the dividend bias take you.
– Why do investors often fall prey to the dividend bias?
Investors may be lured by the appeal of consistent income from dividends, neglecting the opportunity cost associated with capital distribution.
– How does cognitive bias affect decision-making in the stock market?
Cognitive biases, such as confirmation bias, survivorship bias, and risk aversion, can distort thinking and lead to suboptimal investment decisions.
– What are some common cognitive biases in trading and investing?
Confirmation bias, survivorship bias, risk aversion, anchoring, availability bias, recency bias, clustering illusion, endowment effect, gambler’s fallacy, omission bias, and lumpy rewards vs. even distributions are some common biases.