“Personal” Yield With Dividends

by Mr. Cheap

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I love dividends.

Growing up I started investing with GICs and Canada Savings Bonds as a child when interest rates were around 10% (I turned down a 12% GIC at a credit union because I didn’t like the idea of having to buy a share of the union for $40). Naive me, I thought this was a standard ROI and dreamed of future wealth. Fast forward 20 years and the reality of GICs out pacing inflation by 1 or 2% sinks in they start to look a lot more like a wealth protection device than a wealth creation device.

I dabbled in stocks and lost 75% of my money during the tech boom.

That’s why I was so excited when I came across the ideas of dividend-paying (regular money payouts from the company to you the shareholder) blue chips (established companies). It seems to have ALMOST the long term stability of GICs, with the growth potential of the stock market. Pretty sweet.

One of the most fundamental ideas for good dividend stocks is the “Dividend Yield” which is how much you should expect to make on your investment in the next year (a dividend yield of 4% on $100 of stock means you should earn $4 in the next year through dividend payments). For Canadian companies, this dividend is taxed more favourably than interest income (the higher your tax bracket the bigger difference this makes).

Even more exciting is the idea that good companies should regularly increase their dividends. This is like a low-taxed GIC that will randomly increase its payout! There’s a small chance that the company will cut its dividend (which in addition to the lower payments would also cause the stock price to plummet), but that risk is the price for the more attractive gains.

Some people like to talk about “personal yields” which is the dividend-yield of a stock, based on the price you purchased it at. So going back to the above example, if the company increased their dividend payments by 25% to $5 and the stock price increased so that your shares were now worth $125, the dividend-yield is still 4%, but your PERSONAL YIELD is 5% (since you bought the stock for $100).

The fallacy with this outlook is that your shares are now worth $125. You’re ROI is $29 (29% in one year, not too shabby! Of course capital gains taxes would kick in when you sold, but still…), but if you decide to keep the stock and keep collecting dividends, there’s nothing magical about this “pile” of your money and the dividend-yield is still the same (if you like the looks of another stock that is paying 5%, the $125 might be better off there).

By bragging that your new dividend is 5%, you’re lumping the capital gains in with the dividend payments, which isn’t really rational.

Say I bought a GIC for $1000, invested it for a year at 4%, then reinvested the $1040 for 4% for another year. Am I earning 4% or 4.16% in the second year? Clearly I’m making 4%, I’m just confusing things if I want to lump in the $40 gains from the previous year. The only way to decide between buying another GIC or putting the money elsewhere is to ignore the past, look at the current value, and pick what looks like the best investment.

Landlords make a similar mistake when they buy a house and start patting themselves on the back about the financials after a decade. Rents should increase, and you need to compare them to the CURRENT value of the property to see how the property is doing as an investment, not the original purchase price.

Compounding is good, but don’t use it to fool yourself.

There’s probably an economic term for this fallacy, does anyone know it? I think the basic idea is when you segment your money and start looking at the “pools” as separate, you’re in self-delusion territory. If you want to evaluate an investment, factor in the CURRENT value of the vehicle, not the original price to determine the ROI going forward.

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{ 4 comments… read them below or add one }

1

The term, from new behavioral economics domain is “Mental Accounting”. There is a good book about this, see http://www.amazon.ca/exec/obidos/ASIN/0684859386/qid=1143080031/sr=1-1/ref=sr_1_2_1/701-7792439-1849160

You made an interesting point, I never thought about the dividends this way.

Thank you!

2

It’s me again. Just wondering if there isn’t a flaw in the way you’re putting the problem.

If you say that is wrong compare against the original value of our investment because we mix in fact to conceptually different things (dividends and capital gains) – and thus the increased “personal yield” is ilusory, then let’s see what’s happening at the end, when we’d sell the investment: wouldn’t we still receive all the capital gains? If they were “mixed” with the dividends, why didn’t we get them for real, each time a dividend has been distributed? In this light, we can say that at the end we receive both capital gains and the dividends were at an increased rate.

I’d say it’s the same (real) phenomenon when you buy closed-end funds at a big discount. The annual rate of return and the periodic distributions from that fund will get magnified.

So, IMHO, the “personal dividend yield” is not a fallacy.

3

Stefan:

You’re right, we’d receive the capital gains at the end, but we could have received them at any time we wanted (simply by selling the stock). Ignoring taxation, say I bought $100 of a stock paying 4% (I just did, BMO) and say GICs pay 3.25% (which is the current 1 year rate at TD).

Now say at the end of next year BMO value went up to $125, and the dividend yield is still 4% (but for me its now a 5% personal yield).

Say interest rates have gone up to 4.25%, ignoring taxation am I better to buy a GIC with 4.25% interest or keep my 5% personal yield?

$125 x 4.25% = $5.31 – if I sell my stock and buy a GIC
$100 x 5% = $5 (which is the same as $125 x 4%) – if I keep my stock for another year

Clearly the GIC is the rational choice, even thought it offers a lower return then my “personal yield”. That’s why I think personal yield is a mistake when thinking about investments.

You’re right that we could get the capital gains every year, by selling and re-purchasing the stock (or mentally “resetting it” if we didn’t want to deal with transaction costs). This would then keep your personal yield the same as the dividend yield, which in my opinion is exactly the right way to look at the investment.

Of course, you MUST factor in transaction costs and taxation which would make the situation radically different then this super-simple example.

4

Yes, thats it! Mental accounting, thanks!

Mr. Cheap

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