By LARRY SWEDROE
In their seminal 1961 paper, Dividend Policy, Growth, and the Valuation of Shares, Franco Modigliani and Merton Miller demonstrated that in frictionless capital markets, economically rational investors should be indifferent between the two sources of returns: income and capital gains. Thus, in a world where capital gains receive preferential tax treatment, taxable investors should have a preference for capital gains. However, over my more than 25 years of experience as a financial adviser, I have learned that this core tenet of financial economics is at odds with a large body of popular retail investment advice that advocates a rule of thumb of living off an income stream (taking a cash flow approach) while keeping the principal untapped (despite the fact that no one lives forever).
The problem with this rule of thumb is that investors who follow it will necessarily structure their investment portfolio not only to maximize their risk-adjusted return but also to provide a level of current income which, when combined with their other sources of income, matches their desired consumption. Thus, when their income falls due to declines in interest rates, these rule-of-thumb investors alter their portfolio away from safe bond investments (such as Treasury bonds and FDIC-insured certificates of deposit) into higher current income (riskier) assets such as dividend-paying stocks, master limited partnerships (MLPs), real estate investment trusts (REITs), high-yield bonds and emerging market bonds. Such moves can lead to investors exceeding their ability, willingness or need to take risk. The consequences of such moves can be serious if economic cycle risk appears.
Kent Daniel, Lorenzo Garlappi and Kairong Xiao contribute to the behavioral finance literature with their study Monetary Policy and Reaching for Income, published in the June 2021 issue of The Journal of Finance, in which they used data on individual portfolio holdings and mutual fund flows to examine the impact of monetary policy on investors’ portfolio choices and asset prices. Their data sample consisted of individual portfolio holdings from a large discount broker covering 78,000 households over the period 1991-96. They also examined the relationship between monetary policy and dividend-paying stocks over the period 1963-2016. Following is a summary of their findings:
When monetary policy becomes more accommodative, lower interest rates lead investors to shift assets away from the safest investments to higher-yielding, riskier assets such as dividend-paying stocks and high-yield bonds.
A 1 percent decrease in the fed funds rate leads to about a 5 percent increase in assets under management of high-income equity and bond funds over a period of three years relative to their comparable low-income funds. The inflows are likely to come from short-term bond funds and bank certificates of deposit whose current income is depressed by low interest rate policy.
A 1 percent decrease in the fed funds rate is associated with a 2.6 percent increase in the relative valuation of dividend-paying stocks versus non-dividend-paying stocks — statistically significant at the 1 percent confidence level.
There is no evidence that investors regularly withdraw their capital gains.
Reaching for income is mainly driven by retail share classes, not institutional share classes, consistent with the hypothesis that retail investors are more likely to follow a living-off-income rule of thumb. They are also more likely to be subject to behavioral biases than institutional investors (explaining the economically irrational preference for dividends, the “dividend puzzle”).
A reduction in the fed funds rate is associated with significant inflows to funds whose names include words such as “dividends” and “income.”
The increase in demand for current income stream is more pronounced among investors who take a cash flow approach to investing, following the rule of thumb of living off income.
Older investors not only hold more dividend-paying stocks on average, but they are also more likely to reach for income when interest rates fall.
Low interest rates do not significantly increase the demand for high-repurchase stocks, suggesting that investors treat cash dividends differently from share repurchases.
The demand pressure from income-seeking investors drives up the prices of riskier assets, resulting in a lower financing cost for the issuers of these securities, lowering their risk premia.
Both interest rate decreases and increases have significant (and opposite) effects on flows into high-dividend funds. For example, high-dividend stocks experience selling pressure when interest rates rise.
Stretching for income leads to less diversification and greater portfolio standard deviation.
Another important finding was that “the increase in demand for high-dividend stocks following fed funds rate declines impacts the prices of these assets in ways that do not appear to be fully anticipated by the market: high-dividend-yield stocks exhibit positive risk-adjusted returns following monetary easing and negative or negligible abnormal returns following monetary tightening, consistent with investors reacting with a lag to these policy changes. A dynamic long-short strategy that buys high-dividend stocks and shorts low-dividend stocks immediately after falls in the fed funds rate and reverses the positions following rate increases generates, on average, a risk-adjusted monthly return of 0.29 percent, and a 0.455 Sharpe ratio, over the 1963–2016 period. Not surprisingly, retail investors are generally not able to capture this premium because they purchase high-yield assets too long after declines in the fed funds rate when prices are already too high.”
They explained: “Retail investors, rather than benefiting from this shock, continue rebalancing into high income assets even when the prices are already too high, and as a result suffer aggregate losses in their portfolios as a result of reaching for income.”
There was another important finding, consistent with my own anecdotal experience working with thousands of investors. While in a standard New Keynesian model low-interest rate monetary policy usually has expansionary effects on consumption, lower interest rates depress consumption for investors who live off income — which has implications for monetary policy.
Their findings led Daniel, Garlappi and Ziao to conclude: “Reaching for income behaviour constitutes a channel through which monetary policy affects portfolio choices, asset prices, and capital allocation across firms that differ in their dividend policy. … Thus, the reaching for income behavior leads to a link between monetary policy and financial markets that is not explained by the standard New Keynesian models of monetary policy.”
They added that because low interest rates raise the demand for income, mature firms that are able to pay steady dividends will find it relatively easier to raise capital than young, growing firms. And low interest rate monetary policy can induce firms to initiate dividends to cater to income-consuming investors.
An important takeaway for investors is to understand that investors who reach for income move out of those high-income assets when rates rise because deposits and short-term bonds can already provide enough income to finance their desired consumption.
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