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Sent: 31-03-2009 13:42:02
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When Hedging is Speculation Email Newsletter Business Opportunity - Helen Bairstow Dividends & Consumer Spending The Easiest way to do a Client Newsletter. Small business vs. Government
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Dividends & Consumer Spending

Click here to buy - A How To Book of SMSF's by Tony Negline

Lester Wills

As is my want, I often troll through various websites looking for interesting information and to further my research knowledge on a multitude of topics. I recently came across some work that linked dividends with consumer spending. The research was a collaborative study between Stanford Graduate School of Business and both Harvard & New York Universities and was conducted in 2008. It found that if there were two households with investments of the same monetary value, and both sets of investments appreciated by the same amount each year, their spending patterns would be determined by how that increase in value occurred.

To explain the scenario in a little more detail, two households with investment portfolios of identical worth and each household sees their investments appreciate by 10% one year. The only difference is that one household's wealth grows entirely through capital gains; the other receives its additional wealth in the form of dividends. Which household is likely to spend more, and which one accumulates more wealth?

According to this research, the household receiving the dividends is likely to run out and spend the cash. The one with the capital gains is more likely to reinvest or save them. This is very much the sort of thing that sounds obvious once someone says it. The thing is, people often say something is obvious once it has been pointed out, but prior to that, no one noticed the relationship. As the researchers say, in addition to helping understand consumer behavior, the information could even be used to draft economic policy.

Those who have read my previous work will understand that Behavioural Finance comes into play with this result. The differing consumer activity is based on the theory of mental accounting first articulated by Richard Thaler in 1980. He argued that people instinctively group their assets into different categories that they then spend in certain prescribed ways. As the researchers point out, mental accounting is the basis for the popular advice to "consume income, not principal." It argues that consumers do not see capital gains and dividends as interchangeable, but rather as two different kinds of funds earmarked for two different purposes.

According to Stefan Nagel, assistant professor of finance at Stanford, companies have learned that investors often prefer dividends. As is often the case, such approaches may not be particularly rational, however, when companies embark upon stock repurchase programs rather than paying dividends, many 'ordinary' investors are often not happy. The companies argue they are still returning money to investors, but the investors have a different view. As Nagel points out, this consumer behavior is consistent with a widely held perception that dividends, unlike capital gains, represent a permanent kind of income. On the other hand, 'ordinary' investors don't always expect capital gains every year, but they do come to expect dividends.

If this research is a true reflection of consumer behaviour, there are implications for the economy as well as for consumers and businesses. At the consumer level, it's clear that consumers "do have this general rule of thumb of not touching their capital," says Nagel. "In some ways this might not be rational. It might even be sub-optimal for their overall wealth." On the other hand, he says, life is complicated enough. "There's only so much time you can spend thinking about these things," he says. "Economic rules of thumb can work very well for that reason."

Nagel goes on to make the salutary point that at the corporate level, companies are well advised to understand investors' attitudes or risk drawing the wrath of shareholders. Anyone listening out there?

In terms of the overall economy "there is the possibility that understanding this consumer behavior could be used to stimulate the economy," says Nagel. After all, if taxes on dividends are cut, and companies respond by paying out more dividends on which investors pay fewer taxes, there could be a significant increase in consumption. "If you're looking to stimulate the economy, there's the possibility that this could have that effect," says Nagel. Rather takes the wind out of the argument that cutting taxes on things like dividends is accommodating the rich as a large number of mums and dads own shares and receive dividends!

But wait, there's more;

Because consumption is the flip side of saving, this means that in years when dividends are high, consumers save less. "If an investors' portfolio increases through capital gains, the money tends to stay in the brokerage account; if dividends are paid, it tends to be withdrawn, and not put back," says Nagel. "Thus if the government were trying to promote savings, it could arguably encourage corporations not to give out dividends."

Sounds far too rational for politicians to consider, to say nothing of the potential political dogma likely to be spouted by those on the left.

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