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In theory, there is no difference between theory and practice. But, in practice, there is.
Jan L. A. van de Snepscheut (1953 – 1994)
The investor preference for cash dividends has a long history of observation, analysis and, largely, derision. Those in the classical theory camp consider the preference to be irrational and costly. Behavioral economists have been more concerned with explaining what causes it. Practitioners must determine what to do about it with the clients they advise.
Should advisors educate clients on the virtues of a total return approach and the folly of succumbing to the income preference? Or, are there circumstances in which accommodating the preference to some degree is the appropriate tack? Moreover, do the explanations from behavioral economists match real-world observations of client behavior?
To answer those questions, I will look at the research from prominent economists who have sought to explain the preference for income through behavioral finance. Once we understand the basis for the psychological preference for an income over a total return portfolio design, I will turn to the question of how advisors should counsel their clients on this issue.
Why investors want income
In their 1983 paper, Explaining Investor Preference for Cash Dividends, Hersh Shefrin and Meir Statman offered several possible explanations for the preference. The first of these was “self-control,” which is to say that investors have difficulty with delaying the gratification of current spending. Therefore, investors impose on themselves a “spend only the income” constraint to prevent over-spending. But my observations from working with clients who rely on distributions from their portfolios to fund lifestyle needs have not always squared with this explanation. With some regularity, I observe an income preference in retired clients whose probability of meeting their financial objectives is exceedingly high. These clients have no problem with financial self-control.
The second explanation in Shefrin and Statman’s paper relates to prospect theory. That theory describes the way in which individuals confront risk and make decisions under uncertainty. The theory suggests that losses loom larger than gains – that is, a given amount of loss causes a greater emotional impact than an equivalent amount of gain. Larry Swedroe summed up this explanation in his 2017 article, Investors’ Odd Affection for Dividends, by saying that, “sales might involve the realization of losses, which are too painful for people to accept (they exhibit loss aversion).” But my experience is that some clients are averse to selling to generate cash even when they do not know which asset we’re going to choose to sell. If they don’t know which asset the advisor will choose to sell, they cannot be averse to selling only assets marked at unrealized losses.
Shefrin and Statman offered one more explanation related to regret aversion. According to this theory, if an investor sells an asset that later appreciates in price, the investor regrets having sold the asset. Choice and responsibility are key factors here. Since the investor had the choice of which asset to sell, he/she must take responsibility for the decision, leading to regret if the outcome results in an opportunity cost. Because receiving a dividend occurs independently from any action on the part of the investor, the authors theorized that the investor who funds consumption needs from the dividend rather than an asset sale would avoid regret.
On consumption and self-control
I work with several clients who exhibit some degree of income preference. None of these clients has difficulty with financial self-control – quite the opposite. They have difficulty with spending. In Tightwads and Spendthrifts, Scott Rick, Cynthia Cryder, and George Loewenstein found that “the anticipatory pain associated with spending causes ‘tightwads’ to spend less than they would ideally like to spend.” It may actually be quite common for advisors to work with a significant percentage of tightwads. The authors found that in some large samples, tightwads outnumbered spendthrifts by a ratio of about three to two. It isn’t a stretch to imagine that the percentage of tightwads is higher in the population of RIA firm clients than in the general population. (To be clear, I do not refer to our clients as tightwads or spendthrifts.)
In The Behavioral Life-Cycle Hypothesis, Hersh Shefrin and Richard Thaler posited that individuals create three separate mental accounts composed of current income, current assets and future wealth. Shefrin and Thaler argued that individuals have a greater propensity to consume from current income, which would include dividends and interest, than from current assets, which includes investment capital and capital appreciation. Malcolm Baker, Stefan Nagel, and Jeffrey Wurgler confirmed in The Effect of Dividends on Consumption that the propensity to consume from dividends is far higher than from capital gains and, in fact, “similar to the propensity to consume labor income.”
Mental accounting, whereby portfolio income is placed in a mental account that differs from the current asset account, can ease the pain of spending – particularly for tightwads. If the propensity to consume from current assets is lower than from current income and spending inflicts pain on tightwads, it follows that the pain will be less when spending from current income. The instinct that leads us to consume first from current income, therefore can lead some investors to prefer the production of income in their investment portfolios.
On loss aversion
If loss aversion is an explanation for the income preference, what constitutes “loss” should change. Behavioral economists often point to an anomaly known as the disposition effect, which is the tendency for an investor to sell investments that have risen in value and hold investments that have declined in value. This behavior, according to prospect theory, is driven by an aversion to recognize a loss. Shefrin and Statman suggest that a preference for cash dividends may be motivated by an aversion to realize losses when generating cash for distributions. Rather, I have observed an aversion to selling anything – any investment at all. In this sense, the “loss” is not a realized capital loss but a loss (or partial loss) of an asset in one’s portfolio. I’ll share a related observation: Some clients object to selling investment assets even for small cash needs, in some cases going to great lengths to pull available cash from several different accounts to avoid selling.
In The Dividend Disconnect, Samuel Hartzmark and David Solomon stated that, “dividend irrelevance runs counter to intuitions from other areas of life, whereby harvesting fruit from a tree is viewed as fundamentally different to harvesting the tree itself.” To lose an asset in one’s portfolio is to lose the productive capacity of the asset. The client’s stock mutual fund, which you and I think nothing of trimming to meet their cash needs, is their tree. Those shares that we trim are lost.
The authors’ use of the word intuition points to the deeply-rooted instinct behind this preference. Income preference can be thought of as an evolutionary risk-management heuristic.
The advisor response
Hartzman and Solomon end their paper with the following quote: “How best to teach investors about the proper role of dividends in finance remains an open and interesting question.” My experience is that when clients have a strong income preference, teaching them of the merits of a total return approach is not likely to change their preference. This observation is consistent with explanations that relate to basic personality traits and human instincts that have evolved over long periods. These things don’t change easily.
The proper advisor response is not to mock the preference as odd or irrational, but to present the client with tradeoffs. To increase income, what is the impact on portfolio diversification and risk? What is the tax impact? Essentially, what are the disadvantages of attempting to generate additional portfolio income? After learning of the disadvantages, the client still may willingly adopt an asset allocation that is not “optimal” from a portfolio theory perspective or one that is less tax-efficient. This is an informed decision, considering all of their own needs and preferences.
If the goal of portfolio design is to arrive at an allocation that is likely to meet the client’s objectives and one that the client is likely to stick with through varying market cycles, mean-variance optimality is not the critical outcome. Client conviction in a sensible investment strategy is the critical outcome. For certain clients, a modest accommodation of an income preference is the right thing to do.
Christopher J. Sidoni, CFA, CFP®, is chief investment officer and partner at Gibson Capital, LLC, a fee-only registered investment advisor based in Wexford, PA.
 Much of the work on this topic relates to dividends versus capital. I am broadening the topic to include both dividends and interest.
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