Dividends are like crutches. If you can walk properly with out using them, it may be best to

Stockopedia concludes an article on the merits of dividends with an intriguing statement: investors love dividends, but nobody really knows why. I don’t love dividends, but I can supply another reason why many investors do.

Forgetting about tax for a moment, paying a dividend shouldn’t create or destroy any value. It’s a transfer of capital from a company to its shareholders, and since the shareholders own the company, its a bit like transferring money from one bank account to another.

I would separate Stockopedia’s list of reasons investors like dividends into one factor that influences investors’ behaviour and the rest that imply dividends tell investors something valuable about management, or the company.

They might, but they might not.

Apparently, dividends tell us a company is safe, mature, boring, and in rude health, which means it could be overlooked, and therefore cheap. Dividends also take money out of the hands of foolish managers who might waste it.

The problem with this line of thinking is that we’re relying on a proxy, the dividend, which is decided by the policies of management. If we don’t have faith in the management, we shouldn’t invest in the company. If executives are foolish, then the level of the dividend might be too. It might be a safe, boring company, or it might be on the edge of obsolescence.

Metalrax‘s generous dividend almost destroyed it.

Obviously investors can reassure themselves the executives are sensible, and the company will remain viable for more years to come by checking the fundamentals underpinning the dividend; a company’s finances, cash flows, profitability, competitors, markets and so on, but if you’re going to do that, why bother paying any attention to the dividend when there are more reliable proxies for value in the price earnings and price to book ratios? Ed Croft, has covered that in another article. So has Aswath Damodaran.

Another argument for income is high yield portfolios do well in grim markets. It’s probably true, borne out in recent years. But buying a high yield portfolio now because you think market conditions will persist implies you can see the future, and there are so many more exciting ways to make money out of that talent than dividends!

I prefer the behavioural explanation. If you need money, the alternative to taking a dividend is to sell shares, and the category of investor that most needs money now, those in retirement, are least likely to find that easy having spent their lives building capital. It’s less painful if the company liquidates capital for you, and pays it out as a dividend, and less hassle.

There’s an additional behavioural explanation, the one I think income investors most often site. Regular dividends can give investors still accumulating capital the confidence to hold on to shares for the long-term irrespective of what’s happening to the share price. If, as is often the case, investors are their own worst enemies, selling when prices are low, and buying when prices are high, the dividend gives them something else to focus on apart from the treacherous share price.

Dividends are like crutches helping you hobble across treacherous terrain, but if you’re strung enough and can walk properly with out using them, then there may be no need to pay attention to them.

That’s not to say the Thrifty 30 portfolio shuns dividends. In fact the median yield is over 4%. It’s an accidental income portfolio because I try to identify safe, boring companies. I just don’t use the dividend to do it.