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Do Investors Have a Bias for Dividend Stocks?

Can investors be irrational?

It does seem so.

It has long been established that there should be no substantial difference between the total returns of a company that pays dividends as opposed to those that do not.

A $1 per share dividend payout should decrease the price of a stock by $1, as the company loses a net asset value per share of $1.

Without accounting for frictional cost, it does seem that dividend payout should, hence, not matter to long-term investors. Yet, many studies show that investors still seem to continue to over prioritise dividend-paying companies over their counterparts.

So why is this so?

Prospect theory or loss aversion

This theory states that people value gains and losses differently. Because of this bias, people will tend to prefer avoiding losses to acquiring equivalent gains.

Hence, investors who suffer from loss aversion will prefer collecting dividends rather than selling the stock to release capital. This is because the stock may have decreased in value. Hence, selling the stock at a loss will seem worse than collecting dividends and holding on to a stock that has made an equal stock value loss.

However, in reality, cash dividend and selling an equal amount of stock is, in fact, a perfect substitute, as the net asset value of the stock should have changed accordingly. What this means is that whether you sell a stake in your holdings to liquidate some profits or collect dividends, the stocks you own will still have the same intrinsic value.

Regret avoidance

This is the tendency for investors to suffer greater regret when actions are taken rather than not.

Dividends provide a stable income for investors to cash out their investment without making an active decision.

On the contrary, investors who wish to cash out their investments in stocks that do not pay dividends will need to actively sell their shares. For example, investors will feel more regret if they sold $1,000 worth of shares compared to collecting $1,000 worth of dividends if the share prices dropped the very next day.

In reality, this should make no difference to the investor, as the net intrinsic value of his investment should still be the same.

The Foolish bottom line

Investors often make irrational decisions because of behavioural tendencies. These decisions may sometimes cause a bias towards a certain way of thinking or acting.

Relating this back to dividends, about 60% of stocks in America and 40% of international stocks do not pay dividends. Limiting our portfolio only to dividend-paying stocks can, not only limit our portfolio diversification, but may also negatively affect our overall returns.

Meanwhile, for more (free!) investing insights, sign up here for your FREE subscription to The Motley Fool's investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.