This post is the first in a series exploring common myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.

Dividend Myth #1: Companies that pay dividends are inherently better investments than those that don’t.

Many investors take it for granted that dividend-paying companies are superior to those that do not pay a yield. But this idea has been the subject of debate for decades, and many academics believe that it is irrational.

Lets start with something everyone can agree on. Equity returns have two components: capital gains (price increases) and dividends. Add them together and you have the total return for a stock. Ignoring taxes and transactions costs, a stock that pays no dividend but increases in price by 6% provides precisely the same return as one whose share price rises 4% and pays a 2% dividend.

Dividends lead to a drop in share price

What many investors dont grasp is the direct relationship between share prices and cash dividends. If a company’s stock is trading at $20 and it pays a $1 dividend, its share price (in theory, anyway) should fall to $19 on the ex-dividend date. This price drop will not be penny for penny, and it may even be washed out by the normal fluctuations in the daily markets. But there is always a trade-off. After all, when a company that pays out, say, $10 million in dividends, it must be worth $10 million less. The failure to understand this point is the reason so many investors think of dividends as “free money.”

In 1961, Merton Miller and Frank Modigliani published a landmark paper that became the basis for what is now known as the dividend irrelevance theory. They argued that whether or not a company pays dividends should not matter to shareholders, because it does not affect their overall returns. Dividend policy simply determines whether investors end up with a share valued at $20, or a share worth $19 plus $1 in cash.

Not everyone accepts the Miller-Modigliani model. Two other economists, Myron Gordon and John Lintner published a counter argument that has come to be called the bird-in-the-hand theory. Their idea was that shareholders cannot be sure that a company will spend its capital wisely, so a dollar paid in dividends is preferable to one kept as retained earnings. This may be true, but investors who advocate DRIP programs cannot logically subscribe to this theory: if they truly believed it, they would not reinvest their cash dividends in new shares.

The illusion of income v. capital

Why do shareholders believe so strongly that a $1 dividend is preferable to a $1 capital gain? Meir Statman looked at this question in a 1984 article called Explaining Investor Preference for Cash Dividends. coauthored by Hersh Sheffrin. He also reviews the idea in his new book, What Investors Really Want. pointing out that receiving $1,000 in dividends is no different from selling $1,000 worth of stock to create a “homemade dividend.”

Even when this idea is explained to people, most refuse to accept it. Statman suggests that it comes down to a cognitive bias called mental accounting. Investors categorize $1,000 in dividends as income that they will happily spend, but the idea of selling $1,000 worth of stock is “dipping into capital,” which causes them great anxiety. This idea is deeply ingrained in many investors, but it is an illusion, because a company that pays a dividend to shareholders is depleting its own capital .

Other sources of shareholder return

There are other compelling arguments against the inherent superiority of dividend-paying stocks:

• Many companies that pay no dividends use their free cash to repurchase stock. These buybacks increase the value of the remaining shares, which benefits all shareholders. There is no logical reason to prefer dividends over stock repurchases when the net benefit to investors is the same. (Indeed, share repurchases have no tax consequences, while dividend payouts do.)

• Profitable companies that have not reached maturity can often earn much higher return on equity by reinvesting their earnings in growing businesses. Many highly profitable companies (especially in technology and mining) do not pay dividends because they can put that cash to much more productive use. These companies will typically begin paying dividends later in their life cycle, when those growth opportunities disappear.

• It has long been known that the over the long term, small-cap stocks have dramatically outperformed large-caps (with correspondingly more risk). The small-cap premium was more than 3% during the past 80 years. Most small companies do not pay any yield, so investors who select only dividend-paying stocks are ignoring the segment of the equity market that has enjoyed the highest long-term returns.

Investors who use broad-based index funds accept that equity returns come from profitable businesses, some of which pay cash dividends, and some of which put their earnings to work in other equally rewarding ways. In the end, as Meir Statman writes, “a dollar labeled dividends is as green as a dollar labeled capital, so rational investors are indifferent between the two.”

Other posts in this series:

Dividend Myth #2. Dividend investors are successful because they select excellent companies and buy them when they are attractively priced.

Dividend Myth #3. Dividend-paying stocks are a substitute for bonds in an income-oriented portfolio.

Dividend Myth #4. You can beat the market with common sense: just focus on blue-chip companies with a competitive advantage and a history of paying dividends.

Dividend Myth #5. It’s easy to build a well diversified portfolio of Canadian dividend stocks.

Dividend Myth #6. Investors who follow a dividend growth strategy will eventually beat the market on yield alone