By ROBIN POWELL
Let’s face it, we all like the idea of free money. Some will recall the excitement of learning they were in line for a windfall by virtue of having a few pounds saved with a building society that was about to demutualise. Then came PPI compensation payments for loans you couldn’t remember taking out. Personally, just finding a pound coin left in a supermarket trolley can put a spring in my step all day.
The investing equivalent is the dividend payment, except there’s an important difference between dividends and the windfalls mentioned above: they don’t actually make us any better off.
Let’s back up for a moment. I’m not saying dividends aren’t important. On the contrary, they’re an integral part, along with capital appreciation, of an investor’s total return. But it’s a complete fallacy that dividends are effectively free money. Indeed there’s a name for this phenomenon in financial academic circles — the free dividend fallacy.
One hand gives, the other takes away
Simply put, if a company you own pays a dividend, the price of the stock drops by the amount of the dividend. In other words, dividends are not a free handout from a company to its shareholders — they directly affect the overall value of the firm.
The extraordinary thing is quite how enduring this misconception has been. Academics Merton Miller and Franco Modigliani addressed it as long ago as 1961, in their seminal paper on dividend policy, which introduced what is now known as the Miller-Modigliani (M-M) dividend irrelevance theorem.
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STILL CONFUSED ABOUT DIVIDENDS?
You might like to watch in this video we recently made for Index Fund Advisors to explain the free dividend fallacy.
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HOW TO FUND THE LIFE YOU WANT
If you want to learn more about saving for retirement, we recommend you read the award-winning book How to Fund the Life You Want by TEBI founder Robin Powell and Jonathan Hollow.
The book is published by Bloomsbury and is primarily aimed at a UK audience.
Buy the book here on Amazon, or, if your prefer, here on bookshop.org.
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