Wednesday, November 03, 2004

Bounded Cognition

Months ago Microsoft (MSFT) announced a special dividend on Nov. 15 of about $3 per share. They are sitting on a huge pile of cash and don't know what to do with it other than return it to shareholders.

Now, what will happen to the price of a share of MSFT after the dividend is issued? If you go online you can find a lot of discussion and confusion about this point, by obviously very interested individual traders. I have been asked repeatedly about this by fairly sophisticated people.

The answer is that the share price will drop discontinuously by the value of the dividend once it is issued. The argument is kind of trivial: MSFT's future prospects will be the same the instant before and after the dividend, but they will have slightly less cash, so the share price should drop. (Keep in mind they announced the dividend months ago, so there is no new information from the actual payment.)

But, you can find people online discussing a strategy of buying the shares just before Nov. 15 just to get the dividend (which amounts to about 10% of the share price). Not a bad deal, except once you collect the dividend your shares will be worth less. No free lunch.

Talk about bounded cognition - this isn't a hard question like what the dollar-yen exchange rate will be in 3 years. The answer can be deduced by simple logic, but many individual investors are clueless.

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