How To Counsel Clients Who Prefer Income To Total Return PortfoliosAdvisor Perspectives
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In theory, there is no difference between theory and practice. But, in practice, there is. – Jan L. A. van de Snepscheut (1953 – 1994)
The investor preference for cash dividends has a long history of observation, analysis and, largely, derision. Those in the classical theory camp consider the preference to be irrational and costly. Behavioral economists have been more concerned with explaining what causes it. Practitioners must determine what to do about it with the clients they advise.
Should advisors educate clients on the virtues of a total return approach and the folly of succumbing to the income preference? Or, are there circumstances in which accommodating the preference to some degree is the appropriate tack? Moreover, do the explanations from behavioral economists match real-world observations of client behavior?
To answer those questions, I will look at the research from prominent economists who have sought to explain the preference for income through behavioral finance. Once we understand the basis for the psychological preference for an income over a total return portfolio design, I will turn to the question of how advisors should counsel their clients on this issue.
Why investors want income
In their 1983 paper, Explaining Investor Preference for Cash Dividends, Hersh Shefrin and Meir Statman offered several possible explanations for the preference. The first of these was “self-control,” which is to say that investors have difficulty with delaying the gratification of current spending. Therefore, investors impose on themselves a “spend only the income” constraint to prevent over-spending. But my observations from working with clients who rely on distributions from their portfolios to fund lifestyle needs have not always squared with this explanation. With some regularity, I observe an income preference in retired clients whose probability of meeting their financial objectives is exceedingly high. These clients have no problem with financial self-control.
The second explanation in Shefrin and Statman’s paper relates to prospect theory. That theory describes the way in which individuals confront risk and make decisions under uncertainty. The theory suggests that losses loom larger than gains – that is, a given amount of loss causes a greater emotional impact than an equivalent amount of gain. Larry Swedroe summed up this explanation in his 2017 article, Investors’ Odd Affection for Dividends, by saying that, “sales might involve the realization of losses, which are too painful for people to accept (they exhibit loss aversion).” But my experience is that some clients are averse to selling to generate cash even when they do not know which asset we’re going to choose to sell. If they don’t know which asset the advisor will choose to sell, they cannot be averse to selling only assets marked at unrealized losses.
Shefrin and Statman offered one more explanation related to regret aversion. According to this theory, if an investor sells an asset that later appreciates in price, the investor regrets having sold the asset. Choice and responsibility are key factors here. Since the investor had the choice of which asset to sell, he/she must take responsibility for the decision, leading to regret if the outcome results in an opportunity cost. Because receiving a dividend occurs independently from any action on the part of the investor, the authors theorized that the investor who funds consumption needs from the dividend rather than an asset sale would avoid regret.
Read the full article here by Chris Sidoni, Advisor Perspectives