Anti-Dividend Investing: Yield Matters—But Not How You Think!

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Dividends are the comfort food of investing. Who wouldn’t love feeling like they’re getting a seemingly “free” payout just for holding onto a stock? It’s no wonder so many investors are drawn to the siren call of yield. 

As with all good things, there’s a little more—perhaps a whole lot more—to the story. Here’s why: it’s possible that even in a tax-free setting, selling stocks before dividend payouts can lead to abnormal returns.

If this sounds too wild to be true, read on.

The Dividend Illusion

Let’s establish some groundwork to understand the why behind anti-dividend strategies.

First, we must come to the conclusion that dividend distributions do not matter. Convincing investors of this fact has been an uphill battle for academics and evidence-based practitioners. So let’s quickly go over why this is the case and why dividend chasers may be falling victim to their own biases.

When a company pays a dividend, its stock price must drop by the amount of that dividend. The reason is pretty simple: If a company is worth $25, but pays you a $1 dividend, they must release a dollar from their balance sheet to give it to you. Guess what? At a $25 price they had a dollar in their balance sheet, and at $24 they don’t have that dollar – you do!

On top of that, dividends tend to be highly tax-inefficient (especially if they’re not qualified). When issuing dividends, companies are forcing taxable events upon their shareholders. Ouch! 

Still, investors absolutely LOVE their yield. 

So what’s up with the disconnect?

Misbehavior: The Root of Market Anomalies

Welcome to Alpha Architect! You do know we love exploring how behavioral biases shape market anomalies, right?!

Here are three biases that are possibly influencing yield-chasers:

• Mental Accounting: Investors often view dividends as separate “income” rather than a return of their own capital. This mental separation can create the illusion that dividends are a free bonus, rather than just a shift from one pocket (the stock’s value) to another (cash in hand).
• Endowment Effect: Once investors receive dividends, they may overvalue this cash compared to the equivalent value remaining in the stock. The cash feels like a gain, reinforcing the illusion that it’s “free” money rather than just a reallocation of the stock’s value.
• Disposition Effect: Investors often perceive dividends as a safer source of return compared to selling shares. This bias leads to a preference for holding onto dividend-paying stocks while “harvesting” the perceived free income. The illusion of safety stems from avoiding the psychological hurdle of realizing gains by selling shares, reinforcing the mistaken belief that dividends are a “free” reward rather than a transfer of value from the stock’s price to cash.

In fact, according to Sam Hartzmark and David Solomon in their paper, The Dividend Month Premium, because dividends are deemed safer than stock prices, investors actually flock to dividend-paying securities during market turbulence. Wild!

But how do these market forces affect pricing? And how can savvy investors take advantage of this anomaly?

The Dividend Month Premium

Here’s where things get interesting: The Dividend Month Premium paper finds that dividend stocks tend to earn abnormal returns during the month when distributions are expected.

“Consistent with the above intuition, we find evidence of mispricing of stocks whereby companies have significantly higher returns in months when they are expected to issue a dividend […] A portfolio that buys all stocks expected to issue a dividend this month earns abnormal returns of 41 basis points.“(2,3)

Investors’ love for dividends may actually be opening opportunities for evidence-based investors!

Hartzmark’s research uncovered a key insight: before frictional costs, selling stocks before the ex-dividend date can lead to higher returns. Why? Because yield-chasers may be pushing stock prices up between announcement dates and before the ex-dividend date. 

See Figures 2 and 3 in the paper. Abnormal returns build up as a stock nears its ex-dividend date and after the announcement, but decline following the ex-dividend date.

The Proof is in the Pudding

The study constructed two main portfolios:

• The first buys stocks expected to pay dividends during the month and shorts those that are not. 
• The second buys stocks in the month they are expected to issue a distribution and shorts the same stocks in other months.

The results? Consistent abnormal returns, adjusted for other possible risk factors and seasonality explanations.

Additionally:

• Higher-yielding stocks generated greater abnormal returns than lower-yielding stocks.
• Abnormal returns were more pronounced during high volatility episodes.

But how strong is this anomaly, exactly? According to the authors, the return of a portfolio that goes long stocks during distribution months and shorts in other months has had similar returns as the value factor but with less volatility.

Those are impressively strong numbers!

Wrapping It Up: A Smarter Approach

Well, friends, it looks like dividends do matter—just not in the way investors expect. Before frictional costs, savvy investors may be able to take advantage of market misbehavior by going long stocks that are expected to pay a dividend and selling right before ex-div. Of course, this strategy could get eaten alive after taxes. Therefore, one should choose a tax-efficient wrapper if one were to potentially take advantage of these market dynamics.

In a surprising turn of events, it turns out that dividend investors are the yield. 

Happy investing, everyone!

Source: Hartzmark, Samuel M. and Solomon, David H., The Dividend Month Premium (October 1, 2012). Journal of Financial Economics (JFE), Vol. 109, No. 3, 2013.