Investors systemically suffer lower returns when they treat dividends and capital gains as largely independent from one another, according to prize-winning research paper.

“The dividend disconnect”, authored by the University of Chicago’s Samuel Hartzmark and David Solomon of the University of Southern California’s Marshall School of Business, was named Tuesday as the winner of the $15,000 Charles Brandes Prize by the Brandes Institute, a division of San Diego-based Brandes Investment Partners.

According to the paper, many investors, including mutual funds and institutions, “trade as if dividends and capital gains are separate disconnected attributes”. Investors tend to treat dividends as a separate stable income stream and hold high dividend-paying stocks longer, the paper says, and display less sensitivity to stock price changes.

Amid this mistaken view, “demand for dividends is systematically higher in periods of low interest rates and poor market performance, leading to high valuations and lower future returns for dividend-paying stocks,” the paper explains.

Overall, the paper estimates that investors that buy dividend-paying stocks during times of high demand earn roughly 2%-4% less per year due to this behaviour. “An investor whose preferences for dividends cause him to shift into and out of dividend-paying stocks at the same time as other investors would lose a significant portion of the equity premium by doing so,” the paper says.

If investors had a better understanding of the relation between dividends and price changes, they could better evaluate their profits. “How best to teach investors about the proper role of dividends in finance remains an open and interesting question,” the paper concludes.

The runners-up in the annual contest were George Athanassakos, finance professor at Ivey Business School and Vasiliki Athanasakou, assistant professor of accounting at the London School of Economics. They will split a $5,000 award for their research paper on earnings volatility.

The annual competition “seeks to further the conversation on value investing globally”, by offering awards prizes to professors and graduate students for research on investment topics such as value investing and behavioural finance.

Photo copyright: robwilson39/123RF