Homemade dividends

What Is Homemade Dividends?

Homemade dividends represent a form of investment income that investors generate by selling a portion of their investment portfolio, rather than relying solely on the traditional dividends declared and distributed by a company's board of directors. This concept is a cornerstone of the dividend irrelevance theory within portfolio management, suggesting that in a perfect capital market, investors can create their desired cash flow stream independently of a company's dividend policy²⁷, ²⁸. Essentially, if an investor requires cash flow and a company does not pay dividends, or pays less than desired, the investor can sell shares to generate the necessary funds, effectively creating their own "homemade dividends"²⁶.

History and Origin

The concept of homemade dividends is inextricably linked to the groundbreaking work of economists Merton Miller and Franco Modigliani (MM) in their 1961 paper, "Dividend Policy, Growth, and the Valuation of Shares."²⁵ Their Modigliani-Miller Theorem, particularly the dividend irrelevance proposition, argued that in a frictionless market—one without taxes, transaction costs, or information asymmetry—a firm's dividend policy does not impact its stock price or its cost of capital.

T²³, ²⁴he central argument underpinning MM's theory is the idea of homemade dividends. They posited that if a company retains earnings instead of distributing them as cash dividends, the stock price should theoretically increase by the amount of the retained earnings. Conversely, if a company pays a dividend, its stock price should decrease by an equivalent amount on the ex-dividend date. Th²¹, ²²erefore, investors seeking income could simply sell a portion of their shares to replicate a dividend payment, while those wishing to reinvest dividends could buy additional shares. This theoretical ability for investors to self-manage their cash flow streams made corporate dividend policy "irrelevant" in a perfect market.

#¹⁹, ²⁰# Key Takeaways

• Homemade dividends are a cash flow strategy where investors sell portions of their investment portfolio to generate income.
• This approach is rooted in the dividend irrelevance theory, suggesting investors can control their income stream regardless of a company's official dividend policy.
• It offers investors flexibility in timing and amount of income received.
• Tax implications, specifically capital gains taxes, are a primary consideration when implementing a homemade dividend strategy.
• Unlike traditional dividends, generating homemade dividends reduces the number of shares an investor owns.

Interpreting Homemade Dividends

Interpreting homemade dividends involves understanding that they provide investors with direct control over their investment income. Instead of being bound by the dividend payout schedule or policy of individual companies, investors can decide precisely when and how much cash to extract from their holdings. This flexibility allows for a highly personalized approach to managing financial needs and aligns with a wealth management philosophy that prioritizes total return over specific income distributions. By choosing to sell shares, an investor effectively liquidates a portion of their investment, converting unrealized gains or principal into cash. This contrasts with traditional dividends, which are distributions of a company's earnings. The decision to employ homemade dividends often stems from a desire to optimize cash flow, manage taxable account liabilities, or avoid the potential for double taxation on corporate earnings.

Hypothetical Example

Consider an investor, Sarah, who owns 1,000 shares of XYZ Corp., currently trading at $100 per share, making her total investment worth $100,000. XYZ Corp. does not pay traditional dividends, but Sarah needs $1,000 in income for the quarter.

Instead of waiting for a dividend, Sarah decides to create a homemade dividend:

1. Determine Income Need: Sarah needs $1,000.
2. Calculate Shares to Sell: At $100 per share, she needs to sell ( \frac{$1,000}{$100 \text{ per share}} = 10 ) shares.
3. Execute Sale: Sarah sells 10 shares of XYZ Corp.
4. Result: She receives $1,000 in cash. Her remaining portfolio now consists of 990 shares of XYZ Corp., valued at $99,000 (assuming the share price remains $100 immediately after the sale).

This example illustrates how Sarah generated the cash flow she needed directly from her investment portfolio without relying on a company's dividend policy. The value of her overall investment remains the same ($99,000 in shares + $1,000 cash = $100,000), but her share count has decreased.

Practical Applications

Homemade dividends find various practical applications across different aspects of financial planning and investment strategies:

• Retirement Income: Retirees often use homemade dividends as a core component of their retirement income strategy. Instead of seeking out dividend-paying stocks, they can maintain a diversified portfolio focused on total return and sell shares as needed to cover living expenses. Th¹⁸is approach allows for greater flexibility in managing cash flow and potentially optimizes tax outcomes by strategically realizing capital gains.
• Cash Flow Management: Investors can use homemade dividends to tailor their cash flow to specific needs, such as covering a large expense or supplementing other income sources, without being tied to a company's dividend distribution schedule. Th¹⁷is provides a level of control that traditional dividends cannot always offer.
• Tax Optimization: By strategically selling shares, investors can manage their tax liability related to capital gains. For instance, they might sell shares that have long-term capital gains, which are often taxed at lower rates than ordinary income or qualified dividends, depending on their income bracket. Th¹⁵, ¹⁶is can be particularly advantageous in a taxable account.
• ¹⁴ Investment Flexibility: A homemade dividend strategy allows investors to select companies and funds based purely on their growth potential and overall total return rather than their dividend payout history. This expands the universe of potential investments and supports a broader asset allocation strategy.

Limitations and Criticisms

Despite the theoretical elegance of homemade dividends, several practical limitations and criticisms exist:

• Transaction Costs: In real-world markets, buying and selling shares incurs transaction costs (e.g., brokerage commissions, bid-ask spread), which were assumed away in the original Modigliani-Miller theorem. These costs can erode the efficiency of generating small, frequent homemade dividends.
• ¹², ¹³ Tax Implications: While homemade dividends offer tax flexibility, they are not tax-free. Selling shares to generate cash typically triggers a capital gains event, which can be subject to taxation depending on the investor's cost basis and holding period. In¹⁰, ¹¹ contrast, qualified dividends are also taxed at capital gains rates, but ordinary dividends are taxed at ordinary income rates. Th⁹is adds complexity compared to the theoretical ideal.
• Reduced Share Count: Each instance of generating homemade dividends reduces the number of shares an investor owns in a particular asset. Over the long term, this can lead to a depleted asset base and potentially less future growth if the sold shares were part of a growing investment. Th⁸is contrasts with traditional dividends, which, when reinvested, can increase the number of shares held through dividend reinvestment plans (DRIPs).
• Behavioral Aspects: Some investors prefer the psychological comfort of receiving regular, predictable traditional dividends, viewing them as a tangible return on their investment. Th⁷e act of selling shares, even for a planned homemade dividend, can feel like "spending principal," which some investors are averse to, regardless of total return principles. This "mental accounting" can influence consumption patterns.
• ⁶ Market Volatility: Selling shares during a market downturn to generate homemade dividends could force an investor to lock in losses or sell a larger number of shares to obtain the same desired cash amount, further impacting the portfolio's long-term recovery potential.

#⁵# Homemade Dividends vs. Traditional Dividends

The distinction between homemade dividends and traditional dividends lies primarily in their source, control, and implications for an investor's portfolio.

While traditional dividends provide a visible, recurring income stream, homemade dividends offer greater flexibility and may be more tax-efficient for some investors, especially within a tax-deferred account or for those focused on maximizing total return.

#⁴# FAQs

Can anyone create homemade dividends?

Yes, any investor holding publicly traded securities that can be readily bought and sold can technically create homemade dividends by selling a portion of their holdings. This applies to individual stocks, mutual funds, or exchange-traded funds (ETFs).

Are homemade dividends tax-free?

No, homemade dividends are not tax-free. When you sell shares, any profit realized (the difference between the selling price and your cost basis) is considered a capital gain and is subject to capital gains tax. The tax rate depends on how long you held the asset (short-term vs. long-term) and your overall income.

#², ³## Do homemade dividends make sense for all investors?
Not necessarily. While they offer flexibility, homemade dividends might be less suitable for investors who prefer the simplicity and automatic nature of traditional dividend payouts, or those who are sensitive to the psychological impact of selling shares. Considerations such as transaction costs and tax planning complexity also play a role.

How do homemade dividends relate to total return investing?

Homemade dividends align closely with a total return investing philosophy. Total return focuses on the combined appreciation of an investment's value (capital gains) and any income generated (dividends or interest). Investors pursuing a total return strategy may not prioritize dividend-paying stocks but instead build a diversified portfolio and generate income as needed through homemade dividends, recognizing that capital gains are just as valuable as cash dividends.

Is there a recommended "safe withdrawal rate" for homemade dividends in retirement?

The concept of a "safe withdrawal rate" is often discussed in the context of retirement income strategies, which includes generating homemade dividends. While there's no universally guaranteed rate, historical studies and financial planning models often suggest withdrawal rates in the range of 3% to 5% of the portfolio's value annually, adjusted for inflation, to maximize the probability of the portfolio lasting throughout retirement. Ho¹wever, the sustainable rate can vary significantly based on market conditions, portfolio asset allocation, and individual spending needs.