December 3, 2020

Episode 127: Fooled by Dividends, and the Future of Financial Planning Research

December 3, 2020

There is a sharp divide between those who invest in dividend-paying stocks and those who don’t. Underpinning this is the question of whether dividends are relevant to the evaluation of shares. Today we answer this question by digging into the data and parsing the maths before exploring what the future of financial planning looks like. But first, we open our episode with news from the Rational Reminder community — including the fact that we just passed one million podcast downloads. We then touch on lessons from Seth Godin’s new inspiring book, along with the latest from the financial world. Following this, we dive into a discussion on dividend stocks. We begin by unpacking the assumptions behind Miller and Modigliani’s theory of dividend irrelevance. Host Benjamin Felix presents a case study and applies the Fama-French Model to explain differences in returns on dividend portfolios and if dividends truly affect share valuation. After sharing our practical takeaways from Benjamin’s analysis, we move onto our financial planning topic for the week. From technology to retirement decumulation and demographics, we discuss the five key areas which will most impact the future of financial planning. We then wrap up another informative episode with the bad financial advice for the week. Tune in for more insights into the role of dividend stocks and the future of financial planning.

Key Points From This Episode:

Community news, Benjamin’s 3D printing project, and celebrating our 1 millionth download. [0:00:15]
Drawing insights from a recent Ted Seides-Shane Parrish interview. [0:03:44]
Reflecting on Seth Godin’s latest book, Practice: Shipping Creative Work. [0:06:44]
How our culture overvalues outcomes while neglecting the creative process. [0:07:46]
Why having meals delivered to you helps to limit decision fatigue. [0:08:28]
Hear about the new TFSA limits and Tesla’s addition to the S&P 500. [0:09:25]
Exploring whether size affects premium in the US versus elsewhere. [0:12:28]
Why long-only investors may overweight small caps. [0:15:44]
How US junk stocks impact value and their place in your portfolio. [0:16:18]
Introducing today’s portfolio topic; should you invest in dividend stocks? [0:17:53]
Unpacking the assumptions behind Miller and Modigliani’s theory of dividend irrelevance. [0:18:45]
Host Benjamin Felix creates a case study to show Miller and Modigliani’s theory in action. [0:22:38]
Why Miller and Modigliani’s math and idea of financing are based on poor assumptions. [0:26:24]
The predictive power and limits of frameworks like the Fama-French 5-Factor Model. [0:27:25]
Applying the Fama-French Model to portfolio dividend returns. [0:28:28]
Key investing lessons from the notion that dividends are irrelevant to the valuation of shares. [0:31:30]
Reasons why people might only want to invest in dividend-paying stocks. [0:33:20]
The argument that firms seeking external financing may be subject to greater scrutiny. [0:35:33]
Introducing our financial planning topic on the paper ‘Financial planning: A research agenda for the next decade.’ [0:37:02]
Ties between psychology, communication, and financial decision-making. [0:39:02]
Exploring the five key research areas informing the future of financial planning. [0:40:16]
This week’s bad financial advice; invest with active managers. [0:46:31].
What it actually means to say that a fund is actively or passively managed. [0:47:56]

Read the Transcript:

Cameron Passmore: We'll kick it off this week with a great interview that our friend, Ted Seides, did of our other friend, Shane Parrish. As many listeners know, Ted operates the Capital Allocators Podcast, and Ted was actually a guest of ours back in episode 61. Anyways, he interviewed Shane. Shane's based here in Ottawa, and he was also a guest with us on episode 19, and he operates the Farnam Street Blog and also the Knowledge Project Podcast.

It was a really interesting, wide ranging interview about Shane and his background, and it's funny to hear Shane being interviewed as opposed to the interviewer. Talked a lot about his background, how that led him to creating Farnam Street, why and how he gets who he gets as guests, how he interviews them, his decision making process, how he learns from reading, removing blind spots in how he thinks, how he invests. He talked about living through the pandemic and how it's affected him and his team, and how he manages priorities at work and at home. And there was a really net discussion about things that he likes and doesn't like and how he operates each day. So, he tries to put a lot of automatic rules into his life to, as he describes it, reduce the decision load on him. He finds that when he puts a rule in place no one argues with your rules, but he says sometimes people argue with your decision.

An example he gave, he says, "I never have meetings, I believe, before noon. That's my rule." Well, once it's your rule, everyone was fine with it, but if you say it's your preference and you decide not to have a meeting, people typically will try to challenge him. So, he says, as soon as he changes decisions to rules end of any debates.

Ben Felix: Do you know where that showed up for us, is in the leverage stuff because when we talked about leverage and it kicked off the knowledge for people that this a thing that exists and that you can have higher expected returns and everybody gets all excited.

Cameron Passmore: Yep.

Ben Felix: We started having a lot of conversations with clients about it and in a lot of cases we were trying to tell people, "Ah, you know what, we don't really feel like this makes sense in your situation," and we were getting a lot of pushback. So, we decided let's build a framework to make this decision. We made, I think, it was six very specific quantifiable criteria and every time somebody said that they wanted to use leverage we wen through the critera. And it was ratios like income to the debt service ratio, loan to total net worth, loan to investible assets. I can't remember what else there is in there. And now when it comes up, we just boom. Here's the maximum amount of leverage that we are comfortable based on our framework with you having. The conversations are so much easier.

Cameron Passmore: Yeah, that's a great comparison, and so true. The next piece that I came across this past week, I just finished the book by Seth Godin called Practice: hipping Creative Work. I read a lot of Seth Godin's book in the past. It's always been about marketing. The one that really stands out, for me, was the book called Purple Cow that he wrote quite a long time ago. It must be, gosh, 12 of 15 years ago, which talked about standing out much like a purple cow in a field when you bring your product or service to market. Anyways, this latest book, Practice is a very, very different book. It's inspirational. It's basically about everyone simply working on your craft, doing your best, most creative work and putting it out in the world, and then to just consistently work on improving your craft. Just do what you love doing. Do it regularly. Fight against any sort of imposter syndrome you might be suffering from and just enjoy the ride, as he calls it, the ride of creativity.

He talks about how today's society is so outcome focused and not enough people appreciate the process to get to the outcome. It's so outcome focused. His observation is people are going down these predetermined paths to get to some sort of predetermined outcome as opposed to really enjoying the process that you're living to get to what your outcome will be. He highly suggests that people, early on in their lives, to find themselves as a change maker and just find that craft that you're going to continue to enjoy honing to get to what will be your ideal outcome.

Ben Felix : Very cool. I have one other thing to chime in on your notes about Shane when you talked about automation and eliminating decision fatigue.

Cameron Passmore: Yes.

Ben Felix: I know some people aren't going to like this because someone mentioned the Rational Reminder Community that when I talked about having our meals delivered, his wife liked the idea so much that he feels like he's going to go broke now because she wants to do the same thing. And this is about that again. That's one of the other things that's awesome about it is that it eliminate not only the work of actually preparing food and going to buy the ingredients and things like that, but there's no discussion about what you want to eat. You get this thing delivered and it's labeled. Wednesday lunch, dinner. I don't even have to choose between the two really because they give you your lunch and your dinner and your breakfast all at once. You don't even have to choose between the meals that you get. It's like it's labeled, dinner. Oh, good.

Cameron Passmore: It's part of the magic of Costco, right? Limit the choice and make it high quality.

Ben Felix: Right.

Cameron Passmore: A quick news item. TFSA limits for 2021 were announced. $6,000 again for 2021. So, the maximum lifetime limit is now 75,500 if you were 18 years old back in 2009.

Ben Felix: It's getting up here, right?

Cameron Passmore: It is. I remember when it came out. They all had such small amounts of money and lots of paperwork and stuff, but yeah, it's real money.

Ben Felix: Yeah.

Cameron Passmore: The last little news bit that I had was something I saw in the Wall Street Journal on the 22nd of November abut Tesla's addition to the S&P 500. And they go on to say this shows why indexes are so weird. So, finally Tesla was accepted into the S&P 500 Index. As you probably know, it's the 7th biggest company in the US by market cap. And I did not know this, but it was rejected in September, even though it met all the qualifications of being profitable for 12 months. And that's something that, I guess, back in episode 54, David Blitzer, the now retired chairman of the S&P Index Committee, talked to us about all the inclusion rules that they have come up with over the years.

Ben Felix: The inclusion rules and the committee that sits down as a group of humans deciding whether or not, regardless of the criteria... I mean, the criteria have to be met, but sitting down and deciding who's in and who's out.

Cameron Passmore: We used to imagine this transaction that's going to have to happen on the reconstitution because there's right now about $11 trillion of assets benchmarked to the S&P 500. In the article, it talks about how the addition is so large that the reconstitution in December will have to have the car company added in two different chunks. I'm not sure of the timeframe between the two periods, but it's going to have to be done over two periods of time for the reconstitution.

Ben Felix: Wow.

Cameron Passmore: Yep. That's a big deal. I saw another article talk, well, which category will it go into? Technology, consumer products, industrials? What will it be in? I don't know. I didn't get that answer either. Now, you want to talk about small caps?

Ben Felix: Yeah, I do. All on the S&P 500 note, though, when we were talking about revolutions a few episodes ago, that example specifically of the S&P 500 Index going back to whatever it was, I think 1957 and that example in Jeremy Seigel's book. And he was showing if you just never rebalance and help the original companies and the original industries from back then you would have beaten the actual Index. And he alludes to this potentially being the reason why as when does a company get added to the Index while when its price has gone up a bunch recently? And we're seeing that in maybe in an extreme case here. I don't know if there have been other examples this extreme in the past, but the market cap of Tesla shot up so much in such a short period of time and then boom, now it gets into the Index. It's like the growthiest growth stock.

Cameron Passmore: It's up six-fold in price this year and is up 25% on the news of the inclusion, and it's trading at 100 times 2021 forecast earnings.

Ben Felix: I should have bought some in January.

Cameron Passmore: We should have.

Ben Felix: So, small caps. There was a paper that came out in the quantitative special issue of the Journal of Portfolio Management that came out in November. It was a paper looking at small caps, again. The size premium. Paper's called Settling the Size Matter. It's a really good paper. Unfortunately, the Journal of Portfolio Management is subscription... It's not like SSRN where anybody can go and access the paper. A lot of it rehashes information that we already know and confirms it, in the US and internationally, but there is no standalone size premium. That's not really new, although it is interesting to see confirmed again. And I think this is the first time I've seen it confirmed in a paper internationally. Most of the papers tend to focus on US.

So, no standalone size premium, okay. That's interesting. And then it digs into more. What we also know from the paper that AQR did in 2018 that size does matter, according to that, when you control your junk, as they say it. So, when you control for the junk stocks within size. And junk is low profitability, high asset growth, high priced stocks. So, when you control for that and on quality and short junk there is a size premium but this paper split those up into their long and short legs to see where that premium was coming from. And they actually found that it was only coming from the short side. So, if you're long, high quality small caps there's no statistically significant premium. It only comes if you're short, junkie small caps.

Then they did something really interesting that I haven't seen done before, and this is what made the paper interesting enough for me to want to talk about it today, which is that they ran regressions on the Academic Factor Portfolios. People may or may not know this, but in the Fama French Factor, they construct them as 50% large and 50 small. Now, that's a little bit strange because in the market, the market's more like 90% large and 10% small, like by capitalization; but the Factor Portfolios are 505/50, so their effectively over weight small caps.

In this paper they said what if we ran regressions on the Academic Factor Portfolios using a Market Cap Weighted Factor Portfolio? So, we're going to see how well the Cap Weighted Factor Portfolio explains the returns of the Academic 50% small cap Factor Portfolio. They found that it explains a lot of the returns, the Market Cap Weighted Portfolio does, but there are statistically significant alphas on the factors. So, what they're finding, was and the interesting point here, is that even though, we've said this before but it hasn't been said quite well as they did in this paper, all of the factors except, I think, they found except profitability in the United States, all the other factors had additional alphas, additional unexplained risk adjusted returns by over weighting small caps. So, another way of saying that is the other factors are quite a bit stronger in a way that produces a positive alpha in small caps.

Their takeaway, and this is similar to the takeaway that AQR had in their 2018 paper; but again, it was just interesting to see the break out by factors. Their takeaway was that a long only investor may well still want to over weight small cap if they're tilting toward other factors. Other factors being value, profitability, investment, would show up as stronger in size. It's pretty interesting, and I also found that the takeaway that being short, the junkie small caps stock is the only way to get a standalone size premium. That's ones of the things that dimentionalists change in their investment process fairy recently. I think that's the most recent change that they've made is excluding what AQR would call junk. So, they've got these full exclusions in the Dimensional Portfolios for small cap growth stocks, which they've been under weighting for a long time, but then small cap growth stocks with weak profitability. Now, I think the most recent one they've added is small cap with a high asset growth. So, small caps are investing aggressively, and based on this research that we're talking about here, cutting those out is a pretty big deal in terms of capturing any semblance of a size premium.

I thought it was pretty cool, but it also makes you think how important it is to be looking at multiple factors. If you're just looking at one thing, there's a good chance it could look meaningless, like size is the example we're talking about here It's been true for value, too. The Fama French paper last year showed that there was no statistically significant value premium in their out of sample period after their 92 paper. But meanwhile, if you combine value with size, like we're talking about here, the premiums do come back and become statistically significant.

Cameron Passmore: And that was a news story. And for the record, Ben had no notes on that.

Ben Felix: I just read the paper and I thought it was interesting enough to talk about.

Cameron Passmore: It's impressive. Now let's jump into the real portfolio topic, everyone's favorite.

Ben Felix: I have a video, Common Sense Investing video script that I wrote a while ago on dividends.

Cameron Passmore: And I haven't read these notes yet. I haven't had time, so I'm flying blindly at the listeners right now.

Ben Felix: I wrote this, I think it was around, after I did the last video on dividends and saw all of the feedback and comments and everyone defending dividends and why they do matter and all this stuff.

Cameron Passmore: Your video got included in other's videos on YouTube.

Ben Felix: Yeah. That one caused a big buzz in the dividend investing community.

Cameron Passmore: You got hammered pretty good.

Ben Felix: Yeah. It was all pretty baseless, though, which is one of the things we're talking about today, but they enjoyed it, yes. Yes, they did. Where my head was at when I wrote this video was that one of the main points that pro-dividend people latched onto was that the theory of dividend irrelevance from the 1961 Miller and Modigliani paper is basically a bad theory. And they attack the assumptions in the theory to say why it doesn't make sense to base anything on this theory because the assumptions are so ridiculous. It's stuff that's perfect information and costless transactions and nobody impacts prices when they trade and all that kind of stuff. I think I have somewhere in these notes all of the assumptions written out, but the approach that I took in writing this was thinking let's dig into what the theory actually says. And to be honest, I don't think before I wrote this, which was a while ago now, before I wrote this I don't think I was that well versed in what the theory actually says.

It's easy to say, well, dividends are irrelevant because of this paper, but the paper's pretty mathematically dense and I hadn't taken the time to really get it and walk through their examples. So, I did that and wrote this, and then just never recorded it. Then there was a discussion in the Rational Reminder Community recently about why only stocks that pay dividends should have value. So, I dug these notes back up to jump into that discussion, and then remembered that they're kind of interesting.

So, now we're talking about the goal of Miller and Modigliani and their paper in 1961 was to show that it was to prove what investors actually capitalize on when they buy a stock, theoretically. What would a rational investor be paying for? What are they basing their price on when they buy a stock? Is it dividends or is it profits? Or another way of saying that is are dividends relevant to the evaluation of shares, which is where the theory comes from.

Now, one important note here is that they didn't say in the paper that dividends are irrelevant period. It wasn't like dividends are irrelevant, see you later. They said that dividend policy is irrelevant to the evaluation of shares given investment policy. Now that's important and it's another one of the big assumptions that they make actually is that everybody knows what a firm's investment policy is. How much of their profits are they going to reinvest in projects? And you can see the connection to the investment factor here. That's high asset growth would be firms that invest would be firms that invest aggressively.

One of the main points that they're making here, and we mentioned this a couple of episodes ago when we talked about the Gordon Growth Model very briefly when we were talking about the rational story for high prices and technological revolutions. I said that the Gordon Growth Model implies that investment policy and dividend policy are the same thing, and that assumption comes from the idea that financing is only internal. So, in the Miller and Modigliani paper, they refer to this as the special case of internal financing, but then they also go on to say that's not the only case that exists in the world. Firms can finance investments from more than just profits. Make sense?

Okay. So, if we think back to that example, that firm that has profits, the profits can be used to pay dividends or they can be used to invest in projects. And the capital for if a dividend is paid, given an investment policy, the capital for projects would have to be raised somewhere else, like by issuing new shares or taking on debt. And in the paper, Miller and Modigliani take on both of those cases and show mathematically why it doesn't effect the evaluation of shares. If we imagine a firm and they've got these, just easy numbers. So, imagine a firm with $200,000.00 in cash, $800,000.00 in assets at market value, and no debt, and this firm's got 100,000 shares outstanding, each share is worth $10.00.

The firm has opportunities to invest in projects or new assets, or whatever. They know they want to invest, but they also know they want to pay their regular dividend that they typically pay. They're going to pay a $2.00 dividend. So, in this case, the firm pays the dividend, so now it doesn't have cash anymore. Pay the $200.00 dividend to all if its shares. That $200,000.00 of cash that it started with is gone, but then it goes and raises $200,000.00 in new equity. It issues new shares to finance the investments that it had already planned to do. So, the investment policy was given. They were going to make this investment regardless and they just also wanted to pay dividends. Now these newly issues shares are going to dilute the ownership of future profits for the existing shareholders, but those existing shareholders also receive the dividend, which compensates them for the diluted value of their shares. And those shareholders that owned the stock before the dividend was paid, they've now got this $2.00 dividend and they've got an $8.00 share.

The new shares needed to raise the $200,000.00f for the investment are issued at $8.00 per share, the new, lower share price after the dividend was paid. So, they are 25,000 new shares issued. If we step back and look at this company, they've now paid a dividend, they've got $200,000.00 of cash available to invest in their project, and they've got $800,000 in other assets, and they've got no debt. Same as before, pretty much; but they're now 125 shares outstanding. The value per share has dropped to $8.00 because the cash was paid out as a dividend.

If you owned four shares, again, just keeping the numbers very simple. If you owned four shares in the company, your ownership of the company's future profits drops after the dilution; but you could take $8.00 in dividends, $2.00 in dividend per share. You could take your $8.00 and purchase another share at the new $8.00 price, which would take your ownership of future profits back to its previous level. As you can see right there, there's an investment decision that the investor makes at the point when a dividend is paid, which some people argue is a good thing because a dividend investor might argue you can take that and reinvest in an undervalued company as opposed to letting management dictate where the cash goes. So I guess we just see that mechanically happening here.

If that company had not paid the dividend and they had financed the project with the profits, so this is the internal financing case, the investor would not have received any dividends. They would have continued to hold their four shares, worth $10.00 each and their entitlement to future profits would not have changed. So, in both cases, the shareholder is completely indifferent in terms of wealth and expected future returns before taxes are considered. The only difference in the two cases is how the returns were distributed to you, dividends or capital gains. But you can see walking through the numbers that given an investment policy, dividend policy should irrelevant to the fact evaluation of shares because a dividend can basically be not a trick. That's not the right thing to say, but a company has profits to have their investment policy. That's what should dictate the quality of a company. A dividend can be, fake is not the right thing to say. It's not the best signal of expected returns.

I mentioned the Gordon Growth Model where all financing is internal. So, that's assuming that investments can only be financed with profits, and that's like I mentioned earlier. That creates the assumption that dividend policy and investment policy are the same thing, which in reality is not true. That's one of the bunch of mathematical proofs they did in the paper. That's the one that's probably easiest to understand, but for any other case you can think of, they go through the same proof.

Now, this is based on the assumptions that markets are perfect where no trade is large enough to affect the price on their own. Everyone has equal cost and access to information. There are no fees or taxes. Investors behave rationally. The investors prefer more to less wealth and are indifferent between capital gains and dividends. And they assumed perfect certainty, and this is a big one, where investors know each company's future investment plans and profits. So, we don't really know all those things, although with the empirical evidence that went into the Fama French Five Factor Model, we do have pretty good proxies for investment past asset growth tends to be a good proxy for future asset growth, and current profits tend to be a good proxy for future gross profits. So, we don't know with certainty what those ar going to be, but we do have pretty good, at least, statistically meaningful, predictive measures in those numbers.

I think where this gets really interesting is that when we take the Fama French Five Factor Model and look at where it came from, like the Five Factor Asset Price Model is an empirical model, and anytime that you're creating a factor model, you have to choose which factors are going to go into it. Different ways you can do that, you could use a machine learning algorithm, for example, and find the best fit model to the data; but in terms of predictive power, you would expect that to be very good out of sample because there's no theoretical reason for it to continue.

In the case of the Fama French Five Factor Model, they used a dividend policy irrelevance to build the evaluation equation, then formed the construction of the model. And because of that, I think it's pretty interesting to look at how well the Five Factor Model explains differences in returns, including looking at regressions using the Five Factor Model on dividend portfolios because if their model didn't explain the returns of dividend paying companies then we'd expect to see big, statistically significant alphas, which is something that we don't see. So, Fama French took the dividend discount model, keeping in mind in that model dividends are relevant. A dividend policy and investment policy are the same thing. So, with the transformation based on dividend irrelevance, you quickly see that profits minus investment, divided by the discount rate is what we should actually expect to dictate a firm's value, given the theory of dividend irrelevance, given the theory that investors capitalize on profits minus investments, not on dividends, which I think mathematically has to be true, as you can see from the example that we walked through a minute ago. Fama French then divide that by book value of equity so that you can scale the metrics in the equation by book and that spits out the predictions of the Five Factor Asset Pricing Model.

People may be familiar with the predictions already, but it's worth just mentioning them. The first prediction that the model makes is that if you control for expected profitability and investment, firms with a lower price relative to their book value have higher expected returns. That's the value effect that people are familiar with. The second prediction is that given price relative to book value and expected investment, higher expected profitability implies higher expected returns. That's the Profitability Effect. And then the third prediction is that given price relevance to book value and expected profitability, lower expected rates of investment are associated with higher expected returns. And that's the Investment Effect that people tend to be a little but less familiar with.

Now, on their own, each of those effects has strong empirical support. All of the papers leading up to the Five Factor as a pricing model showed strong empirical support for each of those factors in isolation, but the cool thing is that I think it's cool just because it's al tied together with the evaluation of the framework, the article of Evaluation of Framework; when you combine all those together, the Five Factor Asset Price Model is able to explain the vast majority of differences in returns between diversified portfolios. And we wouldn't expect that to be true, I don't think, and I'm not a statistician, but we wouldn't expect that to be true if investors were capitalizing on dividends as opposed to profits minus the investments.

So, it's not a proof. No, I don't think you can prove anything in finance, but it definitely offers support for the theory of dividend irrelevance to the evaluation of shares. And I think one of the practical implications for investors that's really interesting to think about is that even if you're picking stocks, people would say, "Oh, I picked good dividend paying companies," one of the practical takeaways from this is that it makes a whole lot more sense to look for companies with robust profits that invest conservatively, which clears away the muck of a dividend policy, which shouldn't actually tell you a lot because dividend policy given investment policy is just a financing decision.

Whether you're an ETF investor or a dividend stock picker or whatever, it makes more sense to look at profits minus investment, gross profitability minus the growth and book value of assets. That's a better metric. Now, it's harder to find, I guess. Maybe that's a problem. If it's easy to find data in history and there's so many websites dedicated to dividend history, if you wanted to find the gross profitability in growth and assets for a company, that might be a little-

Cameron Passmore: It certainly has the same emotional cache as saying it's a dividend growth payer.

Ben Felix: It doesn't have the same emotional cache?

Cameron Passmore: I think it has huge cache. Having a profitable company below investment sounds great.

Ben Felix: Yeah, it does. It does sound great and it gives you better, cleaner insight into what's actually happening inside of the company. Because you think about the example that we gave earlier, we gave an example of two hypothetical scenarios. One where a dividend was paid and one where it wasn't, but it's the exact same company with the exact same expected return. The fact that it paid a dividend didn't tell us anything. And another way of thinking about that is excluding that company because it didn't pay a dividend, assuming it's got favorable overall characteristic would also not make a whole lot sense. And this is the crux of the discussion on dividends. You're excluding companies that may otherwise be good investments for reasons that aren't necessarily sensible.

I also wanted to just talk about, and this came up in the Rational Reminder Community discussion, too, on this topic actually where people, like Kevin O'Leary, or anyone, you take lot of famous, well-known investors that say, like Kevin O'Leary says, and I quote, "You should only invest in dividend paying stocks." By the way, he's got, I don't know if they still exist, but he had funds and ETFs that only invested in dividend paying stocks. So, mind the conflict of interest there, but I think people like that saying things like that, and maybe this is obvious to the people listening, but that doesn't make dividends relevant to the evaluation of shares, if anything. And there's was paper on this. I can't remember what it was titled. I know Larry Swedroe wrote about it a little while ago, though. There was a paper showing that if there is a preference for dividends, it's like that ESG tastes stuff that we've talked about. If there's a preference for dividends, you would expect that to drive up prices and drive down expected returns.

I don't know how strong the evidence for that preference is, but if you want to make that argument that people like dividends, okay, we'll that should mean based on a taste dividends, you've got lower expected return for those types of stocks. This is how I think, but I think having the theoretical framework to think about these things in the context of some theory. So, in this case we're theorizing the markets are efficient, that's basically the big assumption here, and then evaluating things from that perspective, I think that makes quite a bit of sense. I also think it was useful to go through, it was useful for me, anyway, to go through the theory of dividend relevance and see what were these guys actually talking about? What were thy actually saying? Because the holding investment policy constant, until I really read through the paper, is something that wasn't necessarily obvious when you hear the theory of dividend irrelevance getting thrown around fairly casually. Yeah, that's it. Given investment policy, dividend policy is theoretically and empirically irrelevant to the evaluation of shares.

I hope that example, walking through the company that could have or could have not paid a dividend but maintained the same exact characteristics, exact expected return, same assets, different share price, but same wealth in the hands of the shareholder, just a different distribution of the wealth. One argument that's interesting that I've heard made is that in that example that we just talked though, if the firm a to go out and raise capital, there may be more due diligence applied to them. So, in the internal financing case there's going to be less scrutiny on how they're investing their profits, whereas if they go to raise equity or debt there's going to be an underwriting process and there's going to be more people looking at what are you guys actually investing in. I think that's an interesting argument. I Think for that to mean that dividend paying companies have higher expected returns, we're again assuming markets are inefficient, but it is an interesting point to consider.

Cameron Passmore: So, companies that would be scrutinized less would have higher expected returns?

Ben Felix: No. Well, no. I think if a company is doing less than ideal stuff with their profits, investing in bad projects or something like that, I think that there's a bit of an assumption there if we're saying that the expected returns are going to lower or they realize returns are going to be lower there's a bit of an assumption that the market is not correctly pricing and the fact that that company's doing less than ideal stuff with its profits. But if you're sitting there looking at the market, looking at prices, if there's a company that's not paying a dividend and investing in sub optimal projects, you'd expect that to be reflected in the price. And to say dividends are beneficial because they take that away, I think we're assuming that the market wouldn't be pricing it correctly.

Cameron Passmore: Got it. Anything else to add?

Ben Felix: No, I think that's all for the portfolio topic.

Cameron Passmore: Let's go onto the financial planning topic. This is a discussion paper I came across in the most recent edition of Wiley's Financial Planning Review. The article was called Financial Planning: A Research Agenda for the Next Decade. It's an interesting seven page discussion paper that looks at, as they describe, the challenges, opportunities and future of research and practice in the field of financial planning. They kick off the article just by defining what financial planning is and they describe it as a collaborative process between a client and a financial advisor that integrates relevant aspects of the client's financial and personal circumstances to maximize that person's ability to meet life goals. I think we'd all agree on that. They said it's also felt to be the process of financial planning provides the context for behavioral change related to a household's financial situation and a delivery system for family economics and resource management theories. So, financial planning can be defined as applying economic theory to everyday situations such as the concept of mental processing or bounded rationality in place of the notion of perfect rationality with all of its inherent limitations. The roles of cognition, biases, heuristics, and framing illustrate the growing importance of employing behavioral finance.

There's a really neat chart, it's almost like a Venn diagram, that shows eight interrelated fields of financial planning. Hopefully we get these in the show notes, but they basically, the eight field of financial planning start with behavioral finance, consumer financial decision making, consumer protection policy and regulation, financial therapy, literacy and wellness, household finance, human sciences, portfolio choice, and lastly, psychology and human decision making. I would suggest, Ben, these describe our lives day to day.

Ben Felix: Oh, without question. And we've mentioned, I think in a few past episodes, that we've been doing a lot of work internally on the financial therapy and wellness piece, but it ties into the psychology in human decision making just to help people make better decisions and help us communicate with people in ways that help them make better decisions. It's like you can have really good information, but if it's not being communicated well to all of the stakeholders... When you think about this in the household finance context, it's easy to think about a single do-it-yourself investor that's doing a great job managing their portfolio. They've got index funds, they've got whatever. Maybe they don't need life insurance and so on and so forth. Maybe they're saving a bunch of their income, but when you add a second person, like a spouse for example into the mix, it makes it so much more interesting and it becomes more of a burden to make all these decisions well and to communicate. If a spouse doesn't understand investing at all and they ask why are we invested in index funds or should we be selling to cash because of the COVID crisis, that's not easy.

Cameron Passmore: But it's also, as you said, do-it-yourself investing. Well, investing is only one of these bubbles.

Ben Felix: Right. I'm just talking about the portfolio choice piece. You're right.

Cameron Passmore: There's so much more to it than that. Anyways, so of course there's a survey in there. They gathered data from two different surveys. One from the 2020 Academic Research Colloquium, which is the Academic Research Meeting for Financial Planning. And then they also gathered data from The Center of Financial Planning Survey, 2020 survey. So, a lot of key participants in this industry chimed in with some thoughts.

What they did, they identified the following as the most significant research done in the past decade. The topics were behavioral finance, financial literacy, risk tolerance, and retirement income planning. We've certainly been active in all of those subjects. For the next decade here's the five key areas that will, as they put it, help you financial planning researcher in a way that will significantly improve the lives of individuals.

Number one, technology, and we completely, hopefully I'm accurate in speaking for you, completely agree that technology will have a huge impact for households just to manage finances. They allude to advisors, machine learning, artificial intelligence that can help with portfolio management, risk management, retirement planning. We've seen some very impressive tools that are coming, software, to automate a lot of the financial planning for large companies. So, you can see there's a whole wave of fin tech coming that will help with a lot of this.

Ben Felix: I'm a little bit skeptical. I think that a lot of it is going to improve the productivity of humans. If you think about maybe the Robo Advisor as an example, they've got a nice interface, which is hugely important because people can easily understand what's going on in their account, but what else can they automate or use technology for? I don't know.

Cameron Passmore: I'd love to see a better job of tracking real spending. A lot of people have a hard time knowing what they spend, and to be able to easily... Now, I know you can upload and you can do things with a variety of different platforms, but it's not easy, or as easy it should be.

Number two, the topic is client behavior and psychology. Things like behavioral nudges, psychology, client communication strategies, changing behavior and as we talk about all the time, helping clients make better decisions.

Ben Felix: I think one and two go hand in hand. Having better technology is probably the best way to implement behavioral nudges and things to help with psychology. Don't you think so?

Cameron Passmore: Completely agree. Number three, retirement de cumulation and demographics. There's two main cohorts they talk about, Baby Boomers and Millennials. So, Baby Boomers need help with retirement distributions, estate planning and long term care and Millennials need to focus on wealth formation and portfolio diversification. I'm not so sure if there's that much needed on the portfolio diversification if there's a lot of information and research that is available, but clearly, we're doing a lot of work on the first one for Boomers, which is on retirement distributions.

Ben Felix: Yeah. We have been doing a lot of work on that. That's been one of the really cool things about having Braeden join our team is his ability to digest, because that research is dense mathematically. When that's his world. Yeah, it's just on a different level of statistics and thinking.

Cameron Passmore: Number four, impact investing environmental, social, and corporate governance, ESG, and social responsibility. They talk about a social an environmental consciousness as that rises around the world it'll become more important to understand a model of what moral values people care about and their expression invest in policy and performance. So, talk about a need existing to extend impact, ESG, and social responsibility topics to the individual, to the family, and to households.

Ben Felix: I'm skeptical, as you know.

Cameron Passmore: We know. Number five, ethics. There's much work done by consumer advocates and policy makers to constrain unethical sales behavior. That's something that Michael Kitsis talked a lot about with us when he was on, but they talk about an ongoing need for ethics research in the categories of professional ethics, ethics of knowledge, optimal de cumulation, definition of intelligence, choice architecture and investment selection. I wish they had more details in each of those bullets. They did not. They were just given as bullets.

So, in terms of opportunities that they see, they see a chance to broaden financial planning beyond serving only the higher income households and perhaps technology can help with that. More inclusion of behavioral insights into financial planning and raising awareness, I thought this was interesting, of retirement planning tools and techniques. And they specifically said annuities in there. That's something we've talked about very often.

Ben Felix: Yeah, and it's something that fits right into the de cumulation piece. That's one of the things that Braeden and I have been working on is a better tool to communicate how annuities fit into asset allocation. It's hard to communicate and to show, and it affects other decisions. If you did allocate to annuities, your portfolio withdrawal strategy might be and probably would be materially different.

Cameron Passmore: Okay. That good?

Ben Felix: Yep. I that think that's good. That's an interesting paper and it's interesting to hear a lot about that stuff. I keep thinking about the conversation that we just had with Josh and Brian about the need to not be rational in investment decisions. I still think it's important to start from a point of what a rational person would do and talk yourself out of it, based on other considerations as opposed to just doing what ever feels good. But it is interesting this opinion on where financial planning research is heading. That's one of the things that Josh said in our conversation was that the, I can't remember the exact quote, but the era of the theoretical perfect portfolio is dying. And portfolio shaming is dying and you just do whatever feel right. This speaks to that.

Cameron Passmore: Without being too crazy. It did say that. You said diversified low cost, lower taxes. You said, yes, you have to do that with most of our portfolio.

Ben Felix: Right. It's kind of what I said, I guess. Start from what is rational and talk yourself down from it.

Cameron Passmore: So, for bad advice of the week, I know it's the same theme, so you're going to want to take this and make sure we turn it into a lesson, but it comes from the website Money Marketing and the title is In Defense of Active Management, October 5, 2020. The point of the article is that not all markets are very efficient. It took aim at an article written by our friend in the UK. Robin Powell, argued in an article prior to that, that the markets were in fact quite efficient.

The author argues that the markets are very efficient in developed markets; however, and I quote, "For smaller companies there is limited or no analyst coverage leading to pricing inefficiencies that stock pickers and exploit. More broadly," they continue, "I find it illogical, even churlish to think that the active funds industry is based on quack technical analysis of companies and economics is entirely useless and offers more value. Ergo, any other performance is down to luck." I don't get why a fund manager should invest in terrible companies that are basket cases just because they happen to be at an index. In life in general, we choose the good and reject the bad, so why not with stock selection? After all, the global economy and global stock markets are highly discriminatory. Rewarding certain companies and sectors, such a technology and healthcare and eschewing others like banks, oils, and other value stocks. Why should the latter have to be included in portfolios if they're outdated industries are offered little or no shareholder value?" Okay, Ben, lesson in there?

Ben Felix: It's, to an extent, the line between active and passive gets really interesting here because a lot of the things that he's saying aren't that crazy. To say that global stock markets are highly discriminatory, rewarding certain companies and sectors such as technology and healthcare, that's kind of true and it's one of the reasons that we don't necessarily think that it makes sense for everybody to own a cap weighted index. When you tilt away from large growth and towards small cap value, you're decreasing your allocation to technology and healthcare.

Cameron Passmore: But the line, I don't get why a fund manager shouldn't invest in terrible companies, someone has to own every company.

Ben Felix: Yeah. A terrible company, the lesson there is that a terrible company is not necessarily a terrible investment. In a lot of cases, terrible companies can actually be pretty good investments. It ties into the conversation we had about technological revolution and declining industries actually having really strong stock returns in a lot of cases. It's a estimation errors issue. People tend to think things are going to be worse than they actually end up being, which means that you can collect the value premium. That's a behavioral argument for value anyway.

Ben Felix: But when you realize that someone has to own all stocks, even a terrible company, what would it take for you, Ben, to put down your cash to buy a terrible company?

Cameron Passmore: Right, which is why that's the estimation errors argument. For sure, it's a bad company, so you're not going to pay as much for it, which means your expected return is higher. That's the distinction between a bad company, which there are lots of and a company with bad expected returns, which the biggest one is small cap growth stocks. They're the one type of stock that has really bad expected returns. Small cap growth or IPOs, which tend to behave like small cap growth.

Ben Felix: You'd be glad to know the author does not dismiss the use of index trackers, as he uses them occasionally, but, "The best evidence I've seen for passive funds out performances where markets are steadily rising. For example, during the Golden Decades of the 80s or 90s, or after a global financial crisis where essential banks pumped large amounts of money into the system pushing up asset prices across the board. But in contrast where markets are moving sideways, are volatile or falling, index tracking seems to be a very poor investment strategy."

Cameron Passmore: For this one, you've got ask, okay, show me evidence, because I don't see any paper citations in here. Yeah, no, not a lot of data there. So, show me the evidence that's true because I can show you the evidence to the contrary.

Ben Felix: Well, he answers that. He says, "The active versus passive debate is more complex and nuanced than some would suggest, and those who dismiss active fund management outright are ignoring some key evidence."

Cameron Passmore: Yeah, I don't know. What is active management really? I think it comes down to, because you can argue that using Dimensional funds or Avantis funds are tilting way from a cap weighted index. You could argue. I wouldn't agree with it, but you could argue that's active management, but then the question is why are we saying that the cap weighted index is passive? Or why is the S&P 500 passive? The S&P 500, as we talked about earlier, has a bunch of active decisions going on what gets included and what gets excluded, but who gets to decide on what is passive and what is active? And can we definitively say that active is bad. Well, it depends on the definition. If active means tilting away from the cap weighted index then no, it's not bad. If active means timing the market and holding a concentrated portfolio with no evidence based reason to do so, yes, that's bad.

There is this surge of awareness of passive/index investing and how that's different from active investing, and now we're at a point where people get that passive is good and active is bad, but were also at point where I don't know if people understand what they're saying when they say that. I don't even know doesn't it even make sense to differentiate between active and passive? We have a guest coming on early 2021 who's done some really interesting research on how indexing is basically calling index funds passive doesn't make sense. Adriana Robertson is her name. She even argues, I think, in one paper that index providers should have to register as portfolio managers because they're giving investment advice by creating indexes because so much money is tracking them. And it's interesting to think about. Who decides what is passive? That's a total digression from this.

Ben Felix: Passive is such a loaded word, too. Well, so is active. They're loaded words. Anyways, that was a great explanation.

Cameron Passmore: I think that's the key, though, isn't it? Is this a good investment strategy? Is low cost? Is it broadly diversified? Is it trying to time the market? If the answer is no that's probably good-

Ben Felix: Is it rules based?

Cameron Passmore: Yeah. Sure, is it rules based? Can you increase expected returns? Yeah. Is it tilted towards some of the known risk factors, which would be a good thing? Those are all reasons to invest in something. You could even argue that we talked about Mawer a while ago. As an active manager, they're relatively concentrated, so I think that's a strike against them, but they're also low cost and relatively low turnover. So, how bad are they? Maybe not so bad if you really want active management.

I think it's when you get into a lot of market timing and high turnover and super concentrated portfolios; or alternatively, I guess, high cost diversified portfolios. If you're paying a high fee to own a closet index active fund that's also not ideal. But maybe is a closet index fund that calls itself actively managed really just a passive index fund? I don't know. I don't have the answer.

Ben Felix: We'll leave that thought provoking questions for the listeners. Anything else?

Cameron Passmore: That's good for this week.