Dividends in the accumulation phase

It's a natural instinct to view rising dividends as proof of a company's strength. "Dividend kings" and "aristocrats" often have steady cash flows and conservative management. Yet dividends themselves don't drive returns—they merely reflect underlying quality. Many non-payers share the same traits—high profitability, low leverage, and disciplined capital allocation—while plowing more capital into growth initiatives. Chasing dividends can therefore lead you away from equally (or more) profitable companies that reinvest every euro into expansion.

Why dividend track records can mislead

The famous Miller-Modigliani theorem established that, in perfect markets, dividend policy is irrelevant to firm value—what matters is the underlying cash flows and investment opportunities. While real markets aren't perfect, this insight remains powerful: dividend growers are often financially healthy, but when you adjust for profitability, investment discipline, and leverage, the dividend itself adds no excess returns.

Similarly, studies by Fama and French have shown that after controlling for size, value, and profitability factors, dividend-paying stocks offer no systematic advantage.

Many tech companies like Microsoft, Apple, and Alphabet reinvest earnings in R&D, acquisitions, or share buybacks—generating total returns that often exceed dividend-focused portfolios. By filtering only for dividend histories, you risk overlooking high-growth businesses whose reinvestment engines drive superior long-term performance.

Tax drag: The compounding killer

The mathematics are unforgiving. In most jurisdictions, dividends face immediate taxation while capital gains can be deferred until you sell. Consider a practical example: suppose you invest €100K in two identical companies. Company A pays out 5% annually as dividends (taxed at 30%), while Company B reinvests that same 5% internally. After 20 years:

• Company A (dividend payer): Your dividends, after tax, compound at roughly 3.5%. If you reinvest in Company A after every dividend payment, you end up with approximately €199K
• Company B (reinvestor): The full 5% compounds tax-free until sale, reaching about €265K (before capital gains tax)

Even after paying capital gains tax on Company B, you typically come out significantly ahead. This tax drag compounds over decades, creating substantial wealth differences.

Geographic nuances matter. Some countries like the UK have dividend allowances, while others like Germany have favorable treatment for accumulating funds. However, in most major economies—including the US, France, and Canada—immediate dividend taxation creates meaningful headwinds for long-term wealth building.

The illusion of behavioral benefits

Dividend advocates often cite psychological advantages: regular income provides comfort, dividends offer "forced savings" discipline, and growing payouts hedge against inflation. But these supposed benefits crumble under scrutiny.

The "forced savings" myth. If you truly lack spending discipline, automatic investment plans into broad market funds achieve the same result more efficiently. Setting up monthly contributions to accumulating ETFs forces the same savings behavior without the tax penalty. The "discipline" argument essentially says you need an inefficient mechanism to do what you could accomplish directly.

Comfort during downturns? Dividend cuts often coincide with bear markets—precisely when you'd want that psychological support. During 2008-2009, over 70 S&P 500 companies reduced or eliminated dividends. Your "safe" income stream vanished just when markets crashed. By contrast, diversified index funds don't suddenly stop compounding when times get tough.

Inflation protection? Companies only grow dividends when earnings grow. If you're worried about inflation, you want exposure to companies that can raise prices and expand margins—whether they pay dividends or not. Real assets, broad equity exposure, and international diversification provide better inflation protection than dividend yield.

The behavioral traps that persist

The dividend disconnect is powerful. Research by Hartzmark and Solomon (2019) documented that investors systematically treat dividends as separate from capital gains, spending dividend income more readily than they would sell equivalent shares. This mental accounting error leads to suboptimal portfolio decisions and reduced reinvestment rates. You end up consuming your returns instead of compounding them.

Yield chasing at the worst times. Dividend-focused investors often increase allocations to high-yield stocks during market stress or when interest rates rise—exactly when these assets become overvalued. The "search for yield" drives up prices just as fundamental prospects deteriorate.

Price mechanics work against you. On the ex-dividend date, a stock's price typically falls by roughly the dividend amount. You receive cash, but your shares are worth correspondingly less—it's essentially a forced partial sale. More problematically, this regular cash extraction interrupts the compounding process that drives long-term wealth creation.

The accumulating ETF advantage

Accumulating (capitalizing) ETFs automatically reinvest dividends and interest, allowing you to benefit from compounding without triggering annual taxes. Instead of distributing cash, these funds use income to purchase additional shares internally.

Research by Vanguard and other fund companies consistently demonstrates that accumulating share classes outperform their distributing counterparts on an after-tax basis in most jurisdictions.

Always verify the tax implications in your specific jurisdiction.

Putting it into practice

For taxable accounts:

• Favor accumulating ETFs or index funds to minimize annual tax drag
• Focus on total return rather than yield when selecting investments
• Consider broad market exposure through low-cost funds rather than dividend-focused strategies

For non-taxable accounts:

• In vehicles like the 401(k) (US) or the PEA (France), immediate dividend taxation isn't a concern
• You may choose either distributing or accumulating funds based on preference
• Automatic reinvestment still simplifies portfolio management and reduces behavioral errors

Approaching retirement:

• Consider gradually shifting toward income-generating assets as you near cash flow needs
• Even then, systematically selling shares often remains more tax-efficient than collecting dividends

Conclusion

Dividend-paying companies often represent quality businesses, but the dividend itself isn't what drives long-term returns. During wealth accumulation, the mathematics are clear: tax drag, behavioral traps, and opportunity costs make dividend-focused strategies systematically inferior to broad market exposure through accumulating vehicles.

By prioritizing total returns over current income and letting accumulating funds handle reinvestment automatically, you harness the full power of compounding while avoiding the numerous pitfalls of dividend chasing. Over decades, this approach can translate into substantially higher terminal wealth—and that's what truly matters during the wealth-building phase.

Sources

• Fama, E. F., & French, K. R. (2001). "Disappearing dividends: changing firm characteristics or lower propensity to pay?"
• Hartzmark, S. M., & Solomon, D. H. (2019). "The dividend disconnect."
• Miller, M. H., & Modigliani, F. (1961). "Dividend policy, growth, and the valuation of shares."