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Why do shareholders prefer Current Dividend over Capital Gain?
When it comes to pay dividends, companies may choose two paths. One is paying out the dividends as they are generated and the other one is paying it on a later payment cycle in the future. The latter is known as capital gains in financial terms. Now, which one is more appealing to the shareholders? It is the former without any doubt.
Shareholders prefer current dividends than capital gains for a host of reasons. However, the two that make the most impact are uncertainty and portfolio diversification. Let’s discuss these two factors individually to get a better understanding of the shareholder’s preferences.
Markets are Uncertain and Volatile
According to the MM model of dividend policy, in a perfect market, there is no risk because the rate of return on investment stays constant over time. In such a condition, there is no uncertainty of change of share prices. So, there is no loss in holding the shares forever.
However, in practice, uncertainty is the only constant in the share market. Therefore, there are risks associated with the capital gains too. This means that, a shareholder who is keeping shares in his portfolio for future gains may have to face a loss due to the risks associated with the firm’s and share’s performance in the market. Therefore, shareholders being natural risk avoiders tend to get current payout instead of capital gains.
Portfolio Diversification
Another common reason which lets the investors choose current payout over capital gains is diversification of portfolios. It is a fact that with diversification, the risks of loss in the share market can be mitigated to a large extent.
As the portfolio is made with a view to diminish the uncertainty and risks, the shareholders benefit from the situation where a set of profit-making shares are chosen over the loss-making ones. Choosing the profitable opportunities lets the shareholders buy more of profitable shares instead of the ones that are riskier and more uncertain in paying out the dividends.
Higher payout can also be achieved by choosing the shares of companies with a strong financial background instead of the ones that do not perform well in the market.
Conclusion
It is a matter of fact that the current payout is better than capital gains for the average shareholders. There are many other reasons why investors prefer to receive current payouts, such as time value of money and erosion of value of shares due to passing time.
Shareholders being allowed to sell their shares in the market to raise funds can benefit from current payouts rather than future payments. That is why it is a norm for shareholders to prefer dividend payout that are offered sooner rather than on a later date in the future.
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