When one buys a bond or a CD, they are buying an agreement that obligates the issuer to pay x percent of a specific amount on certain dates and pay a specific amount upon a specified maturity date. In most cases, people conceptualize interest as an amount paid in addition to principal.
By contrast, neither the amount of a dividend nor a principal value is guaranteed. In fact, the act of paying a dividend, in effect, reduces the principal amount. Many clients do not know what trading ex-dividend means or why it happens. A fairly effective way of explaining how dividends payments get to them is through a simple illustration.
Ask the client to imagine handing a $5 bill to the next person that comes down the sidewalk. Now ask, did your net worth increase, decrease or stay the same. The answer, of course, is their net worth declined by $5.
The same thing happens to a corporation when it pays a cash dividend. It takes money out of its account and hands it to shareholders. The stock trades lower by the amount of the dividend to reflect the decrease in the company’s net worth.
As a receiver of the payment the shareholder’s net worth is unchanged. It has just changed form a little. Instead of just owning the stock, the shareholder has $5 cash and stock worth $5 less. If owned in a taxable account, the shareholder now gets to pay taxes on the dividend.
Most clients don’t realize that the cash to pay the dividend came from coffers filled after corporate taxes were paid and the distribution is not deductible to the corporation. Most also don’t understand that cash paid for dividends aren’t available to be reinvested in staff, facilities, research, development, marketing or any other activity management may want to undertake to improve the health of the business.
Once clients understand these things, they can see why dividend payers are a minority in the market. Many think dividends are a sign of corporate strength and in many cases, they are, but what is viewed as a strength can become a weakness. Just ask GE. Some companies hurt themselves by continuing to pay dividends because they fear a negative reaction from the market or make themselves less competitive.
Dividend-Paying Stocks Are A Good Substitute For Bonds
Yield-obsessed clients can bite on this one a lot. The dynamics I described above can help people get over this one because they see many of the elements of uncertainty involved. Unfortunately, there is a lot of press out there suggesting dividend-paying stocks are great sources of income and dramatically safer than non-dividend-paying stocks.
In addition to the discussion about what happens when a dividend is paid, I’ve also found a simple chart showing the behavior of dividend-focused funds during the financial crisis helps keep client enthusiasm in check. The purported relative safety in some dividend payers pales in comparison to the safety inherent in good-quality bonds and CDs. Look at just about any dividend-paying fund or ETF and its clear, the dividends were of little help if any during the crisis while good-quality bonds were a true safe haven.