Dividends: real income or an accounting illusion?

A dividend is cash leaving the company and arriving in your account. It feels like being paid for owning something. It is not quite that, and understanding the difference will save you from the single most common trap in income investing.

The bit nobody tells you

On the day a share goes ex-dividend, the price drops by roughly the amount of the dividend. This is not a coincidence or a market reaction. The company is now worth less, because the cash that was inside it is now inside your account.

So why do dividends matter?

Because of what they signal, and what happens if you reinvest them.

• They are hard to fake. Cash paid out is cash that indisputably existed. A long, unbroken, rising dividend record is one of the better proxies for genuine earnings quality.
• They impose discipline. A management team committed to a dividend has less cash lying around to spend on empire-building acquisitions.
• Reinvested, they are most of the return. Over multi-decade periods, reinvested dividends have historically accounted for a very large share of total equity returns.

The yield trap

A stock yielding 12% is not generous. It is usually a stock whose price has collapsed because the market has concluded the dividend is about to be cut. The yield is high precisely because nobody believes it. When the cut arrives, you lose the income and you have already lost the capital.