Wednesday, August 29, 2012

Stress Testing Your Dividend Portfolio

As I explained in my article on my dividend retirement plan, I invest in blue chip dividend stocks which can afford increase dividends for decades. Once the dividend income from my portfolio exceeds my expenses I would consider myself financially independent. However, I realize that there are many risks I need to minimize, in order to be able to enjoy the continued stream of rising dividend payments.


The types of stocks I purchase tend to be companies with wide moats or strong competitive advantages which have pricing power and customer loyalty. These companies have been able to expand sales and profits and managed to pay a higher dividend in the process every year. These companies are attractively priced at the time of purchase and have sustainable dividend payments. The fact that these companies have paid rising distributions for years if not decades and the fact that they offer above average yields is just icing on the cake. The types of companies I invest in include Johnson & Johnson (JNJ), Wal Mart Stores (WMT), Chevron (CVX), Enterprise Product Partners (EPD). There are several risks however, which would be dividend retirees need to consider.

One risk which is seldom addressed by most financial advisors is broker failure. Most clients at SIPC insured brokers will be able to get back up to $500,000 in assets or $250,000 in cash in case their broker fails. If this broker had no internal controls to keep customer funds segregated, investors which hold more than the SIPC insured level risk receiving pennies on the dollar in assets that were rightfully theirs. As a dividend investor, I would hate to lose even a portion of my income stream just because my broker fails. As a result, my dividend growth plan made certain that I spread my assets across several brokerages and that I do not commit more than $100,000 per brokerage. I plan on putting a smaller amount in comparison to the SIPC limit because I expect my stocks to deliver solid capital appreciation over the next few decades. In addition, it is much easier to spread my funds across brokerages $100,000 at a time, than $500,000 at a time.

Another risk which I continuously stress is diversification of my individual portfolio. I hold more than 40 individual stock positions in my dividend stock portfolio. I hold a full-time job, and still manage to find time for my portfolio and have a life as well. If two stocks that I own eliminated their distributions in an equally weighted 40 stock portfolio, I would suffer a 5%decrease in portfolio distributions. Chances are that if my other companies keep raising distributions at the 6% expected rate, my dividend income would break even for the year. If you have a 10 stock portfolio, and two of the stocks you owned eliminated distributions, your income would be down by 20%. I witnessed the collapse of dividend income for many dividend paying financial darlings such as Citigroup (C ), Bank of America (BAC), US Bancorp (USB) and Wells Fargo (WFC). This experience has also taught me to not overcommit to a certain sector. If a dividend investor has equally weighted exposure to 8 sectors, and the companies in one of these sectors experience severe decreases in distributions, the total portfolio income would not be decimated. Compare this to a typical portfolio from before the financial crisis, which could have been heavily weighted towards financials, and you would understand my conservatism. Another example lies with the investors in Canadian Royalty Trusts were blinded by the high yields in the sector. Fast forward several years, and most of these investors have suffered massive decreases in distributions.

A third risk that could derail anyone’s retirement plans includes deflation. This economic condition occurs when the general price level declines due to lack of demand and oversupply. The US experienced massive deflation during the Great Depression of 1929 – 1933, when the Consumer Price Index fell by 27%. Stock prices fell by 91% in July 1932 from their highs reached in September 1929. Dividend payments on Dow Jones Industrials Index fell by 73% during the same period as well. The only component that would have saved investors’ portfolios were US Treasuries, which kept paying their coupons. The past 20 years in Japan have also showed investors that allocation to government bonds is the best investment during deflation. I have long been ridiculed for my ideas that retired investors should have at least a 25% exposure to fixed income – US Treasuries or Agency Bonds being the safest fixed income. The truth is that investors who plan on relying on their portfolios for income in retirement should have exposure to assets which have different economics. Stocks and Rental Real Estate should do well during moderate inflation and during periods of economic growths. They are also going to maintain some purchasing power during high inflation. Bonds on the other hand would maintain their income stream during severe recessions, depressions and deflations. While 10 year US Treasury Bonds yield less than 2% today, there were several times over the past two years when they yielded close to 4%. Currently, 30 year Treasury Bonds yields 2.70%, but they used to yield close to 5% on several occasions over the past few years.

The key to accumulating fixed income is purchasing a set amount every month or so. I plan on using the dividends from my stock portfolio for 5 years before my retirement date to purchase fixed income. While current yields look low, they could still go lower or remain low for extended periods of time. The yields on long-term Japanese Government bonds have been declining for years, as have the yields on US Bonds. Two years ago, Roger Nusbaum ridiculed my article on Four Percent Rule for Dividend Investors in Retirement    by claiming that bond yields were low and could only go up. Little did he understand that bonds play in important role that diversifies a retiree’s portfolio and passive income stream against unforeseen events. To Japanese savers in the late 1990s, a 10 year bond yielding 2% might not have sounded like much. Fast forward to 2011, and it is hard to even obtain that yield in a 10 year JGB.

Last, one of the final rules I have is to immediately sell a stock after it cuts or eliminated dividends. This would have had investors sell Citigroup in early 2008, Bank of America (BAC) and Lehman Brothers (LEH) before the bankruptcy. This rule ensures that I get out of a position with negative income characteristics that could wipe out a portion of my capital. It also ensures that I sell a company which I like, even if the fundamentals have deteriorated over the years. Eastman Kodak paid dividends for many decades, but when the company cut distributions in 2002 at the time that the stock traded at $30/share. This was 9 years before the company filed for Chapter 11.

8 comments:

  1. I'm not using a broker for my investing. I'm using ComputerShare, BNY Mellon, and Wells Fargo ShareOwner services for my dividend investing. This may limit my choices some since not all dividend-paying companies offer direct purchasing plans, but when purchased this way, the stock is in my name and not held in a brokerage.

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  2. The 25% bond allocation is not unreasonable at all. I suspect the US will not have Japanese style deflation, but you never know.

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  3. I am LOVING your blog. I came upon it at the perfect time for me too. I had to move a 401K and also realized I could consolidate a SIMP IRA to my traditional. So, all of a sudden, my 3 accounts became 1 IRA. I also realized that the broker that had been managing the IRA and 401K, that I had to use through my company had been charging me 2%.

    Now, I'm re-working my entire portfolio following your method and also moving to a fee free brokerage.

    Thanks so much for the insights and well written articles.

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  4. << A third risk that could derail anyone’s retirement plans includes deflation. ... I have long been ridiculed for my ideas that retired investors should have at least a 25% exposure to fixed income – US Treasuries or Agency Bonds being the safest fixed income.>>

    Investors might want to check out the Permanent Portfolio. Google is your friend here, or read "Fail Safe Investing" by Harry Browne. Bonds are part of the Permanent Portfolio.

    Part of my investment protfolio includes the PRPFX mutual fund (a very small part right now), but there is also the PERM ETF that was launched earlier this year. Investors can "roll their own" Permanent Portfolio using a variety of index ETFs. I plan on increasing my exposure to this style of investing in future years as a "just in case" hedge to supplement my dividend growth portfolio.

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  5. Your post is very relevant today, as a stock I own, Permian Basin Royalty Trust (PBT), recently reduced its monthly payment and took a nose dive this week. However, it still yields 8% at the current price and I am still up in the stock as I purchased at $9. Although, their cut is due to low oil prices as the dividend is based on fuel prices and the fuel pumped out of their oil producing properties. Do you consider the cut in this case as an indication of things to come as you write in your post, or a buying opportunity as long term fuel prices will rise?

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  6. Another stress test to consider is what happens if your expenses unexpectedly jump. One approach is to overdesign your dividend growth income to handle such possibilities.

    For example, let's say your monthly expenses are USD 3,000. Aim for an average monthly dividend income of, let's say, USD 4,000 (or whatever). Then if your expenses unexpectedly jump, or some of your dividend payers cut their dividends, you still have some wiggle room to accommodate the change and may not have to go back to work to make ends meet.

    If the growth rate of your dividend income exceeds the inflation rate, and you hold the rate of increase of your expenses to the inflation rate (except for the unexpected jumps), an increasing "margin of safety" will happen automatically over time.

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  7. Your blog is quite interesting and your approach insightful. But I question the practicality or necessity of carrying a portfolio of 40 stocks. If you truly believe that then most investors would be better off looking for an appropriate ETF or mutual funds. I do not believe that there is any statistical validity of taking the portfolio to that size and reducing the risk of loss. Although I may not know the right answer, something to consider.

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  8. Nice article. I too am heading towards 40 stocks, the only problem is cutting it down to 40 ;) I can easily hit 50.

    I am not so sure I can keep $100k at each broker. If/when I get to my goal of $2million, then that would be 20 brokerages I would have to keep track of. I think I would lean towards the $500,000 limit and stick with 4.

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