because dividends help them surmount self-control problems through the
creation of simple rules.
A second rationale for dividends is based on mental accounting: by desig-
nating an explicit dividend payment, firms make it easier for investors to
segregate gains from losses and hence to increase their utility. To see this,
consider the following example. Over the course of a year, the value of a
firm has increased by $10 per share. The firm could choose notto pay a
dividend and return this increase in value to investors as a $10 capital gain.
Alternatively, it could pay a $2 dividend, leaving an $8 capital gain. In the
language of prospect theory, investors will code the first option as υ(10).
They may also code the second option as υ(10), but the explicit segregation
performed by the firm may encourage them to code it as υ(2)+υ(8). This
will, of course, result in a higher perceived utility, due to the concavity of υ
in the domain of gains.
This manipulation is equally useful in the case of losses. A firm whose
value has declined by $10 per share over the year can offer investors a $10
capital loss or a $12 capital loss combined with a $2 dividend gain. While
the first option will be coded as υ(−10), the second is more likely to be
coded as υ(2)+υ(−12), again resulting in a higher perceived utility, this
time because of the convexity of υin the domain of losses.
The utility enhancing trick in these examples depends on investors segre-
gating the overall gain or loss into different components. The key insight of
Shefrin and Statman is that by paying dividends, firms make it easier for in-
vestors to perform this segregation.
Finally, Shefrin and Statman argue that by paying dividends, firms help
investors avoid regret. Regret is a frustration that people feel when they
imagine having taken an action that would have led to a more desirable
outcome. It is stronger for errors of commission—cases where people suffer
because of an action they took—than for errors of omission—where people
suffer because of an action they failed to take.
Consider a company that does not pay a dividend. In order to finance
consumption, an investor has to sell stock. If the stock subsequently goes
up in value, the investor feels substantial regret because the error is one of
commission: he can readily imagine how not selling the stock would have
left him better off. If the firm had paid a dividend and the investor was able
to finance his consumption out of it, a rise in the stock price would not
have caused so much regret. This time, the error would have been one of
omission: to be better off, the investor would have had to reinvest the divi-
dend.
Shefrin and Statman try to explain why firms pay dividends at all. An-
other question asks how dividend paying firms decide on the size of their
dividend. The classic paper on this subject is Lintner (1956). His treatment
is based on extensive interviews with executives of large American companies
in which he asked the respondent, often the CFO, how the firm set dividend
60 BARBERIS AND THALER