An important step in portfolio management after crafting a tax-efficient asset allocation policy is to decide how to take exposure to the desired asset classes.

For those taking direct exposure to asset class, this requires deciding the investment style, say growth or value, large-cap or mid-cap. For those who prefer mutual funds, the decision also involves choosing between dividend and growth. The question is: How should investors choose between these two options?

This article applies behavioural finance to explain why investors have to think beyond tax effects to choose between dividend and growth option. It also shows how the choice fits within the core-satellite framework.

Growth or Dividend?

Suppose an investor follows the core-satellite framework to achieve an investment objective such as a certain post-retirement lifestyle. The core portfolio is typically a passive exposure to a broad-cap index such as the S&P CNX 500 or a large-cap index such as the S&P CNX Nifty. The satellite portfolio is created to generate excess returns over the benchmark index (alpha) in the short term.

Now, investors' choice between dividend and growth option is typically driven by tax considerations. The recent Budget, for instance, changed the tax on dividends distributed money market mutual funds. Such changes could make a tax-efficient investment sub-optimal. It is, therefore, important to look at factors beyond tax effects before deciding on the dividend and growth options.

We apply behavioural finance to argue why dividend option may be optimal. Our argument rests on the fact that every investment has two sources of returns — dividend and capital appreciation.

For investors who take direct exposure to equity or MFs, the responsibility of generating dividend cash flow is on the companies or with the asset management firm. Capital appreciation, on the other hand, shifts the responsibility of earning the cash flow to the investor and this leads to several behavioural biases.

One, depending only on capital appreciation for returns exposes the investment to high risk. This leads to a behavioural bias called Regret Aversion. That is, investor could regret if the asset moves up after she sells it. Or she could regret if the asset declines after she decides to hold it. The regret is caused due to error of commission (selling the stock) or error of omission (not selling the stock). In either case, the error committed now could lead to sub-optimal decision in the future.

Choosing dividend can help moderate the Regret Aversion Bias. The investor can “emotionally” distance herself from the cash flow decision, as it is the responsibility of the mutual fund to time dividend payments.

Moreover, dividend option on index funds (passive core) fits well within a retirement portfolio. Dividend helps investor take profits on a continual basis and shift the money to bonds. This process aligns with the portfolio's objective of having higher bond exposure towards the retirement date.

And, two, individuals typically suffer from Mental Accounting. This refers to a bias where individuals treat income returns as different from capital appreciation — dividends are marked as return on capital and are available for current consumption.

Capital appreciation is treated as return of capital and cannot be used for current consumption. This distinction is useful for retirees who need continual cash flow to sustain their lifestyle.

Individuals should consider behavioural biases and not just tax effects before choosing between dividend and growth for core portfolio. Dividend is unimportant for the satellite portfolio, as its objective is to generate excess returns or alpha through market timing or security selection. We discussed only two biases that bring to the fore the importance of dividends. There are several other biases such as Loss Aversion and Psychological Reactance that are equally important.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at >enhancek@gmail.com )

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