Question

Hi Max. You made a fantastic point in your posting! When it comes to dividends, history is often a good indicator. If a company has never paid dividends in the past, then it would not be reasonable for an investor to have the expectation for dividends in the current year. While it may be possible, it certainly would not be probable. On the flip side, if a company has paid a steady dividend every quarter for the past ten years, then it would be fairly reasonable to expect some sort of dividend in the future. Class, if a company with a history of paying dividends decided to suddenly stop paying those dividends and reinvest the monies in the business instead, how do you think stockholders might react?

Answer 1

Stockholders reaction depends primarly on Informational perfection of the market. If the informetrics regarding return on investment from prospective investments made in business, risk perception of management in new investments are made available to investors before taking a decision - stockholders can react in most rationably. That means, if they find ROI more than what they can earn from alternative investment sources, they will continue to hold the stock, despite of not paying dividend. Blindly following a trend in dividends or demanding of continuing of a trend ignoring oppurtunities coming in the way is not a rational behaviour expected from investors.

Secondly, liquidity concerns of few investors cannot be ruled out. All investors need not be investing their savings. There may be investors borrowing for the purpose of investing. Such investors may liquidate a part of their holding to meet their liquidity needs. From behavioural finance point of view these investors practices are not treated as rational.  

Other segment includes short term investors very keen on capital gains and posible short term dividend earnings who cannot tolerate the with holding of dividends will also opt to liquidate their holdings.This is again an irrational reaction from a part of the investors.

Thus the cummulative impact of all the above indicates that price of the stock tends to move a little bit down from its intrinsic value but very soon restors its value when rational investors steps into abitrage process. ( gaining from irrationality of few investors)

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