PROYECTO INTERNACIONAL PIERRE AUGER

Here is a long-standing puzzle in traditional finance: Why do indi- viduals have a strong preference for cash dividends? This is especially puzzling considering that dividend income is taxed at a higher mar- ginal rate than capital gains.

Consider the example demonstrated in Table 14.1. You own 1,000 shares of a $100 stock (a total value of $100,000). If the stock pays a 1% dividend, then you receive $1,000 and the stock price falls to $99 per share (the 1,000 shares are now worth $99,000). The decrease in the stock price is the amount of the dividend paid. However, if you are in the 28% tax bracket, then you keep only $720 after taxes. In sum, you end up with $720 in cash and stock worth $99,000.

Now consider the alternative. Assume that the stock does not pay a dividend. If you want some cash, you must sell 10 shares at $100 a share to receive the $1,000 proceeds, thus creating your own divi- dend. This is called a homemade dividend. You are now left with 990 shares of a stock worth $100, for a total of $99,000. If the stock sold has no capital gains liability, then you owe no taxes and keep the

INVESTMENT MADNESS:How psychology affects your investing…and what to do about it 153

Unscrupulous brokers invoke fear, greed, pity, and other emotions to cause you to abandon your usual deliberation process in favor of a quick decision to buy whatever the broker is selling.

entire $1,000 in cash. Note that you are better off creating your own dividend. If the stock had a cost basis of $50 a share and capital gains are taxed at 20%, then $100 is owed in taxes. You are still better off making your own dividends.

If you wish to maximize your wealth and cash flow, you should seek income through homemade dividends rather than cash divi- dends. However, people seem to prefer cash dividends. This behavior seems irrational in traditional finance, but it can be explained by investor psychology. Consider the following case:

Because of the steep rise in oil prices in 1973, Consolidated Edison Company of New York experienced a large decline in income. Consequently, that year they omitted paying the divi- dend, which had been paid for 89 consecutive years. At the 1974 annual meeting, angry shareholders confronted manage- ment, demanding a restoration of the dividend. Widows queried, “Who is going to pay my rent?” People claimed that they were going to have to survive on only their Social Security checks.8

154 SELF-CONTROL, OR THE LACK OF IT! chapter 14

REAL DIVIDENDS VERSUS HOMEMADE DIVIDENDS

Table 14.1

Received Homemade

Dividend Dividend

Starting number of shares owned 1,000 1,000 Beginning price per share $100 $100 Beginning stock value $100,000 $100,000

Per share dividend $1 $0

Pretax dividend income $1,000 Dividend by selling 10 shares

Selling shares pretax income $1,000 Ending number of shares 1,000 990

Price per share $99 $100

Ending stock value $99,000 $99,000 Taxes

Income Tax (28% marginal rate) $280 $0 Capital Gains Tax (20% rate, 50% gain) $0 $100 After Tax Income $720 $900

Why didn’t these people simply create homemade dividends? There are two psychological traits that explain this behavior: mental accounting and self-control. First, making homemade dividends probably didn’t even occur to these investors. Mental accounting (Chapter 8) causes investors to separate investments into different mental accounts. When investing for income, investors buy high- dividend stocks, bonds, and annuities (Chapter 9). A different men- tal account and investment strategy is used for capital gains. It is difficult to think of a stock in the income mental account as having the potential to capture a capital gain.

These mental accounts can be useful for investors who need to exert self-control. A retired person may recognize that her wealth needs to outlive her—i.e., she doesn’t want to outlive her money. Because she may be tempted to spend too much money, she enacts a common rule of thumb to help with self-control: never touch the

principal. This rule is a helpful reminder to avoid overspending.

However, it can also inhibit creative thinking that increases income—like homemade dividends. Therefore, sometimes it pays to bend the rules a bit.

SUMMING UP

You may need to invoke self-control management techniques, such as making rules of thumb and controlling your investment environ- ment. These techniques can help you avoid the mistakes caused by letting your emotions and psychological biases influence your invest- ment decisions. However, you should also understand why the rules exist and be able to bend them if creative thinking allows you to increase your wealth. Chapter 15 reviews your psychological biases and proposes some specific strategies, rules of thumb, and manage- ment techniques that help you to overcome those biases to improve your wealth.

INVESTMENT MADNESS:How psychology affects your investing…and what to do about it 155

ENDNOTES

1. P. 92 of Kenneth Fisher and Meir Statman, 1999, “A Behavioral Framework for Time Diversification,” Financial

Analysts Journal, May/June: 88–97.

2. This discussion is from Richard Thaler and Hersh Shefrin, 1981, “An Economic Theory of Self-Control,” Journal of

Political Economy 89: 392–406.

3. This example is proposed in Ted O’Donoghue and Matthew Rabin, 1999, “Doing It Now or Later,” American Economic

Review 89(1): 103–24.

4. George Ainsle, 1991, “Derivation of ‘Rational’ Economic Behavior from Hyperbolic Discount Curves,” American

Economic Review 81(2): 334–40.

5. These ideas are explored in Richard Thaler and Hersh Shefrin, 1981, “An Economic Theory of Self-Control,” Journal of Political Economy 89: 392–406; Stephen Hoch and George Loewenstein, 1991, “Time-Inconsistent Preferences and Consumer Self-Control,” Journal of Consumer Research 17: 492–507.

6. George Akerlof, 1991, “Procrastination and Obedience,”

American Economic Review 81(2): 1–19.

7. Benjamin Ayers, Steven Kachelmeister, and John Robinson, 1999, “Why Do People Give Interest-Free Loans to the Government? An Experimental Study of Interim Tax Payments,” Journal of the American Taxation Association 21(2): 55–74.

8. This case is summarized from Hersh Shefrin and Meir Statman, 1984, “Explaining Investor Preferences for Cash Dividends,” Journal of Financial Economics 13: 253–82.

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