05 Apr Investing for Dividends – A Behavioural Perspective
I liken the local financial blogging scene to a community. I enjoy my time reading what others have to say about the personal finance and investment scene in Singapore. We exchange ideas and encourage each other on our financial journeys. As an ecosystem, it is healthy and growing and we are proud to be part of it.
Some time ago B from A Path to Forever Financial Freedom updated about his dividend payouts. It generated a deluge of comments. One of the very first was from aloypro who asked if it is better to invest for capital gains or for yields, especially for someone with a small amount to start off with.
Popular finance pundit Winston Wisdom Koh, inspired by B and also AK, shared his thoughts on facebook. Again, many weighed in with comments.
The topic of capital gains vs yields is obviously very close to investors hearts. This issue pops up in our day to day conversation often. Alvin wrote about the pros and cons of dividend investing some weeks ago. He suggested looking to stocks for gains and bond for yields.
Let me add to the fray by looking at this issue from a behavioural finance perspective.
The questions at the heart of the entire saga is this – Should an investor be buying stocks for yields or capital gains? My stand is simple. All other things being equal, it is easier for investors to look to the equity market for yields than for capital gains, for the couple of reasons listed below.
Psychologist B.F. Skinner used rats as proxies to study human behaviour. Skinner is interested in how behaviour can be shaped by rewards.
He suggested four different schedules, namely fixed ratio, variable ratio, fixed interval and variable interval.
The setup is simple. Install a rat in a cage. There is a lever in the cage which the rat can press. When the rat presses the lever, a pallet of food appears. The rat is happy.
Now imagine we want to teach the rat lever pressing behaviour. And we can control when and how the food appears. In a fixed ratio schedule, each lever press will result in a pallet of food.
Of course we can up the ratio and allow two pallets to appear with each lever press. The ratio becomes 1:2 but the principle remains that lever presses will result in food. In this case, the rat quickly learns that in order to get more food, he just needs to hit the lever.
In a fixed interval schedule, food drops are time dependent. We can set the time interval to be say, five minutes. Food will be dispensed every five minutes as long as within that time frame, the lever is pressed at least once. The rat quickly learns that more lever presses will not result in more food. Rather, food will appear at fixed intervals as long as the lever is activated within that interval.
Variable ratio and variable intervals schedules are, as the name suggests, random in nature. The former rewards the rat with different amounts of food with each lever press. Sometimes many, sometimes none. The latter rewards the rat at different times. Sometimes food will appear in a jiffy after a lever press, at other times, it will appear after a very long period.
Which reward system is most effective?
Back to the original intent. If what we set out to do is to train the rat to achieve consistent lever pressing behaviour, which set of reward system would be most effective?
Undoubtably, the rat learns well and fast when exposed to the fixed ratio and interval schedules. On the other hand, the rat becomes confused when rewards are variable in nature. Lever pressing behaviour is well established in the former and easily extinguished when rewards are variable.
Transpose the principles to investing in stocks. Think of investors as rats and buying stocks as lever pressing. To obtain food, rats must press the lever. To derive profits, investors must stay vested. When food comes randomly, rats get confused and stop their lever pressing behaviour.
When buying stocks for capital gains, the rewards, if any at all, are random and variable. Investors cannot impose their will on the market and demand capital gains. There is no indication as to when profits will come after buying a stock. It could be a week or ten years. It could be ten percent or a thousand percent. The human mind is not made to handle this kind of uncertainty.
Investing for dividend turns the entire game around. Owning a company that has a stable dividend policy allows the investor to know exactly when to expect payouts. Buying REITs for yields achieves the same results. (Purists would say that dividends are not fixed, but variable ratio. I agree but with the right companies, the uncertainty is much lesser). This is a very comforting thought. Investors are able to project their cashflow and returns. This is what keeps many players in the market.
There is (almost) no other options.
The other option is to buy bonds for yields. Bonds are instruments of debt. MoolahSense CEO Lawrence Yong explains the distinction between bonds and stocks in a recent interview.
There is an adage in Finance. Equity investors look at a glass half full, while Fixed Income (Bond) investors look at a glass half empty.
When companies issue equity, they sell ‘hope’ to investors. Investors buy shares on the hope that they company will deliver on the projections. If a company exceed the projections, there is no cap on the returns that an investor may get.
When companies issue debt, they make a ‘promise’ to investors. When a company borrows, they commit to repay investors the principal with interests on a scheduled date with a maturity period. Even if a company does well, their returns will be capped. But if a company becomes less profitable, they are still required to repay the debt at the contracted rate and time period.
First things first, the bond market in Singapore is practically non-existent. Despite recent pushes by SGX to make corporate bonds more accessible to the general public, at this moment there are only six offerings.
Unlike the stock market, people have always thought of the bond market as for high net worth investors. Such a mindset will take a generation to change. For the retail investor seeking constant yields, going to the bond market requires additional knowledge and a largely contrarian streak. It requires someone to be an early adopter.
Behaviorally it is cognitively taxing. It is not an easy task to venture out. It is much easier to go along with the flow. As such, many remain addicted to dividend stocks for yields while ignoring the bond market totally.
Traditional Finance vs Behavioural Finance
Traditional Finance theories posit that human beings are rational and markets are efficient. Behavioural finance on the other hand places investors as ‘normal’ and often not fully rational. While the rational human seeks to maximise gains and minimise losses, the normal human is wired to seek pleasure and avoid pain.
And that includes the pain of waiting indefinitely for uncertain capital gains, that of having to learn and discover a foreign instrument which few are buying is too much to bear.
Allow me to leave you with this quote from Warren Buffett.
In investing, what is comfortable is rarely profitable.
The market rewards you for your discomfort. Conversely, comfort comes at a cost. Is it a cost you are willing to bear?