Why do you believe dividend investing is flawed?

Category: Investment

We have written a post previously about focusing on income when investing. I wanted to go into some of the evidence behind focusing on income when investing not being the best strategy.

When looking at this, there is probably no more famous theory in Finance than Modigliani/Miller. Known as the Dividend Irrelevance Hypothesis it says investors should not worry about a company’s dividend policy.

What did the paper look at?

The paper aimed to look at what investors are trying to get out of buying shares in a company. If we think of a company with profits, they can use them to pay dividends or to invest in projects. If they use them to pay dividends, they might have to use other ways to raise capital for projects.  This could be by issuing new shares or taking on debt. In the paper, Miller and Modigliani look at both and mathematically proved they do not affect the valuation of shares.

Is there any more evidence?

Another famous finance theory, the Fama French Five-Factor Model, has a starting point of dividend policy being irrelevant. Since its publication, the model has been able to explain the majority of differences in returns between diversified portfolios. We would not expect this to be true if superior returns were coming from dividend-paying shares.

Are there any arguments for the relevance of dividends when investing?

An older model, the Gordon Growth Model suggested that shareholders prefer current dividends. This suggests a positive relation­ship exists between dividend and market value. The logic put behind this argument is that investors are generally risk-averse, and they prefer the current dividend. This would conform to the adage “a bird in the hand is worth two in the bush”. However, attaching lesser importance to future divi­dends or capital gains. This may be true but if a model with dividend irrelevance at its heart can explain why different portfolios behave differently, it cannot be too significant.

If you want to have a chat about this and what the best investment strategy for you could be, feel free to book in a free no-obligation chat here or get in touch.

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