Investing Psychology by Tim Richards

Author:Tim Richards
Language: eng
Format: epub
ISBN: 9781118722220
Publisher: Wiley
Published: 2014-03-29T00:00:00+00:00

LESSON 8

Deciding how we invest based on how the neighbors or the in-laws are doing is a one-way ticket to lottery hell. This is madness; we need to set ourselves sensible, measurable goals, not ones determined by the luck or skills of others.

DIVIDEND DILEMMAS

One of the odder bits of framing, suggest Hersh Shefrin and Meir Statman,24 has to do with how we treat dividends from stocks. People tend to get very, very angry at dividend cuts, even though these are often in their best interests, because sometimes retaining funds that would otherwise be paid out to shareholders is the best way for a corporation to raise money to invest in new ideas. The researchers propose that although stocks are treated by most people as belonging to the lottery portfolio, the same people tend to treat dividends as belonging to the insurance portfolio—which is peculiar, but no more so than a range of other behaviors we've seen.

In fact, dividends may offer an interesting route out of some of our more damaging psychogical traits. Shinichi Hirota and Shyam Sunder25 have shown that the difference between vaguely rational investors and very irrational ones can be explained by the way in which they use dividends to anchor their expectations. Investors who use dividends as a starting point for valuation analysis are basing it upon something they can't affect, and this provides a basis for rational analysis of future earnings. The alternative seems to be to base valuation analysis on share price and this leads to the nasty issue of market reflexivity we discussed earlier: share prices can be a self-fulfilling prophecy under certain circumstances.

Further evidence supporting this idea shows that where there is unusual uncertainty about the future trajectory of dividends it's quite likely that the share price of the stock will get out of whack with its fundamental valuation. Basically, the anchor of the dividend is no longer reliable, and no longer a basis for rational analysis. Of course, stocks that don't pay a dividend will also be harder to value: as many of these are high growth or speculative corporations to start with it's easy to see that the valuations of these can often disappear on a tangent of their own, regardless of reality, whatever that may be.

Given this type of extrapolation from dividends to future earnings it's not hard to see why people get a bit upset at dividend cuts, as they cut across rational analysis. Nonetheless, valuation methods that include dividends are far less susceptible to social pressures than those merely based on share price. A dividend is generally not determined by how much investors want it to be, but a share price may be.

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