Why Do Investors Buy Dividend Stocks?

Vanguard is one of the world’s largest brokerages. It grew to be as large as it is because it developed low-cost investment options like mutual funds and index funds, which put owning stocks into the affordable reach of millions of people.

Earlier this year, Vanguard polled its investors because they had a question about why they had chosen to invest the way they had. The investors in question had invested in the company’s Equity Income Fund (Index: VEIPX). The fund is composed of stocks that pay relatively high yield dividends, so investors owning the fund could expect to get dividend income from their investment in it once a quarter.

Except most their investors were choosing to pass on pocketing that income. Vanguard portfolio manager Sharon Hill describes what they were doing instead:

“We call the fund Equity Income, and we focus on stocks that offer above-average dividend yields,” said Hill, head of the Global & Income Active Equity team within Vanguard Quantitative Equity Group, our in-house active equity manager. “But on the days the fund distributes dividends, we generally don’t need to raise much capital. Most of the investors reinvest their dividends in the fund.”…

“We thought, ‘Why would investors own an income fund if they didn’t want the income?’” Hill said. “So we decided to ask them.”

They asked more than 5,000 investors why. They found the practice wasn’t limited to the Equity Income Fund:

The results showed that across Vanguard’s five equity income funds—those with the terms “high dividend” or “income” in their names—only 12% of investors said they needed the income produced by the funds. More than 80% said they reinvested the dividends. Interestingly, equity income fund investors were no more likely to withdraw their dividends than investors in other equity funds.

Why would such a large percentage of investors plow their dividends back into the funds they had invested? As Vanguard notes:

In theory, in the absence of tax and trading costs, investors shouldn’t care whether they receive their returns in the form of dividends or price appreciation. That’s because a dividend payment reduces a company’s value—and, all else equal, its share price—by the amount of the payment.

Since Vanguard provides options to invest in growth-oriented funds, which pay little-to-no dividends so their investment gains come purely from their growing in value, it wouldn’t seem to make much sense for investors to invest in their income-oriented funds. Especially if they were just going to reinvest the dividends they earned back into the funds.

Here’s what behavioral economist Paulo Costa found after they asked why:

About half of investors said they own equity income funds because they prefer to invest in dividend-paying companies. Many of these investors said they believe that the stocks of companies paying high dividend rates have higher returns and lower volatility than other stocks, and that such companies care more about their investors than companies paying low dividend rates.

“These results suggest investors derive emotional benefit from investing in dividend-paying stocks, in addition to the more utilitarian, financial benefits,” Costa said.

When investors were asked why they reinvested their dividends, about 80% cited a preference for compounding returns. About 70% said they reinvested because they didn’t need the dividends for immediate spending. “Many dividend reinvestors may be positioning themselves to receive income at a later date, to meet future spending needs,” Costa said.

Here’s the chart capturing the responses Costa received when asking the dividend re-investors why they were reinvesting:

While Costa focused in on the behavioral aspects of the survey responses, the surveyed investors indicated they had a rather important financial incentive to reinvest their dividends: “they believe that the stocks of companies paying high dividend rates have higher returns and lower volatility than other stocks”.

According to the Wall Street Journal‘s Spencer Jakob, who reviewed Vanguard’s study, they’re right.

Data from the past 50 years compiled by Ned Davis Research shows that the annualized return of dividend payers in the S&P 500 was 9.2%, compared with only 4.3% for nonpayers, and with less choppiness too.

Dividend payers would have left you with 10 times as much wealth before taxes over that time as nonpayers. They also easily beat an equal-weighted basket of all companies in the index.

Earlier this year, we presented the following chart based on Ned Davis Research’s data for the period from January 1973 through September 2024. Here it is again, where we find the returns are very close to the figures Jakob cites:

Generally speaking, dividend payers tend to have better returns with relatively less risk.

Related Reading

Going back to the question of whether investing in growth stocks versus dividend stocks (or stock funds) is more advantageous, we’re going to point you to the very thought-provoking article Dividends Aren’t Magic by Beyond Saving at Seeking Alpha which has a rather remarkable conclusion. We won’t spoil it for you, but it is well worth reading the whole thing, if only because it reinforces a key point Vanguard learned from their dividend reinvesting investors….

Image credit: Cash Dividends by Nick Youngson on Picpedia.org. Creative Commons CC-BY-SA 3.0. Alpha Stock Images.