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Picking the Fruit

John Lim, 3:04 am ET

LAST MONTH, the Federal Reserve released the results of its latest stress tests of major financial institutions. As an investor in Wells Fargo, I took special interest in the Fed’s findings. Why? If Wells Fargo passed the Fed’s stress test, it would be allowed to raise its dividend, which currently stands at a paltry 10 cents a share, amounting to a dividend yield of just 0.9%.

I’m fully aware that my obsession with stock dividends is less than rational. For one thing, I don’t spend them. My dividends are automatically reinvested in additional Wells Fargo shares. Nor do the dividends necessarily increase the value of Wells Fargo stock. Every dollar in dividends paid out to shareholders lowers the price of a company’s stock by the same amount—at least in theory. That’s why a stock often falls in price on its ex-dividend date, which is the first day a stock trades without the benefit of its next dividend.

And since I don’t actually spend my dividends, I really ought to prefer capital gains. After all, dividends are taxed the same year I receive them, but capital gains aren’t taxed until I sell the appreciated stock. In fact, the tax on capital gains may be avoided altogether by donating appreciated shares or bequeathing stock to your heirs, who inherit the stock with a step up in basis. Finally, I can always create “homemade dividends” by simply selling some shares as needed.

When economists examine the irrational behavior of dividend lovers like me, they scratch their heads. In 1976, economist Fischer Black pondered the conundrum in a paper titled The Dividend Puzzle. In his words, “The harder we look at the dividend picture, the more it seems like a puzzle, with pieces that just don’t fit together.”

But guess what? I still love my dividends—and I’m not alone. Meir Statman uses a wonderful metaphor in his book on behavioral finance, Finance for Normal People, which I think gets to the heart of people’s love affair with dividends. He describes dividends as the fruit harvested from an orchard, with the trees in the orchard representing the stocks. Investors love to pick the fruit but are loath to chop down the trees. When I sell shares of Wells Fargo to generate homemade dividends, it feels like I’m depleting my orchard.

Such mental accounting may explain why many people are too frugal in retirement, spending far less than their nest eggs would safely allow. They may be falling prey to the orchard mentality, living off their portfolio’s income but hesitant to draw down their portfolio because of an irrational fear they’ll deplete their orchard. I could certainly see myself behaving that way, which is one reason I’m strongly considering buying single premium income annuities for my retirement.

In case you’re wondering, Wells Fargo passed the Fed’s stress test and announced a doubling of its dividend to 20 cents a quarter. While that’s a far cry from its pre-pandemic 51-cent dividend, I’ll take every penny I can get, thank you. Wells Fargo also announced plans to repurchase $18 billion of shares, amounting to 10% of its current market capitalization. In effect, that increases my ownership stake in the company by 10%… meh.

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Philip Stein
Philip Stein
9 months ago

John, isn’t reinvesting your dividends in additional shares the basis for compound growth of your investment? If dividends are merely spent or shares are sold when cash is needed, there is no compounding.

For a long-term investor such as yourself, wouldn’t growing the number of shares you own through dividend reinvestment be more valuable than enjoying a lower capital gains rate after selling shares?

johntlim
johntlim
5 months ago
Reply to  Philip Stein

Absolutely true, Philip!

Purple Rain
Purple Rain
10 months ago

Regarding the dividend obsession, I see it as insurance against my own behaviour. Last year during the flash crash in March, what did you think helped the average investor sleep better at night?

An index? Or a basket of dividend growth stocks that kept steadily paying you despite what the market was doing? I was less inclined to add to my indices in the 401(k) when the market crashed. I was busy shoveling all my cash into my dividend growers. They helped me sleep better at night. It is purely behavioral, not logical. But investing is 90% behavioral.

johntlim
johntlim
10 months ago
Reply to  Purple Rain

There is a lot of truth to your observation. Dividends are fairly consistent and much less volatile than stock prices. Receiving cash dividends brings home what stocks really represent and help many investors stay the course.

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