Wednesday, April 23, 2014

Dividend Growth: The Risk of Being Cocky

There are many risks to investing. One of the major risks that could ruin a portfolio’s chances of generating adequate dividends are purely psychological. Investors who act/are overconfident in their abilities, tend to rush through, and make silly mistakes that could be disastrous. Being cocky might work in certain areas of life, but not in investing on the financial markets.

One of the risks that overconfident investors take is when they create a concentrated dividend portfolio. These concentrated portfolios typically include no more than ten to fifteen individual securities. These cocky investors claim that they create these concentrated portfolios because they are only investing in their best ideas. According to these investors it is much easier to focus all your energy on ten individual stocks and research all there is to them, than to focus on thirty or more companies. The reason why I view these investors as overconfident is because they are forgetting that sometimes, no matter how great you are at analyzing investments, some unknown factor might cause you to still lose money. If just one out of ten companies eliminated dividends and fell substantially in the process, it could mean trouble. Contrast this to a portfolio of 30 companies, which is properly diversified and allocated to different sectors. An unexpected blow to one company would not jeopardize the dividend income stream.

One other thing that makes me wonder about investors with concentrated portfolios of stocks is the sleep well at night factor. I sleep very well at night knowing that I personally own more than 40 individual dividend paying stocks. That way, if I picked the next Enron or Bank of America (BAC) who cut or eliminated dividends, I would still have 38 more positions which would maintain and even increase dividends. In a ten stock dividend portfolio, one or two stocks that cut or eliminate distributions could spell trouble.

In my portfolio, I have a decent allocation of Energy stocks. I own or have owned Exxon Mobil (XOM), Chevron (CVX), British Petroleum (BP), ConocoPhillips (COP) and Royal Dutch Shell (RDS/B). In 2010 BP had the big issue with the oil spill. I truly believed that it would not have that big of an impact, and imagined it would be similar to the Valdez issue with XOM in 1989. At this point I was speculating that nothing would happen. In hindsight, I should have sold right when the first bad news broke in 2010, but instead I held on. I replaced BP with Royal Dutch Shell when the dividend was eliminated. Some would argue that in a concentrated portfolio where BP was held, the owner would have had a much faster response than myself. To this I say, great but you cannot simply afford to sell at the moment that there is any slight chance of trouble in a business you are invested in. Otherwise you would never hold any company for any period of time. My ability to hold on to positions has been rewarded in the case of Johnson & Johnson (JNJ), when they had big recalls in 2010. In addition, simply selling all financials indiscriminately during the 2007 – 2008 financial crisis would have been a mistake as well, as some companies actually maintained distributions. M&T Bancorp (MTB) is a prime example of a company which maintained its dividends, despite the fact that it was one of the TARP recipients. I never added money to my small position from 2008 however, which is why it is merely a footnote in my list of dividend holdings today. However, I have recovered almost one-quarter of my purchase price from the dividends received since 2008.

Another argument that proponents of concentrated dividend investors use is the quote from Warren Buffett “Diversification is protection against ignorance”. I have a great respect for Buffett, but know that unfortunately, there is only one Buffett. The Oracle of Omaha has had his Berkshire Hathaway investment’s pretty diversified over the past 40 - 50 years. He has made some pretty bad bets in the past, including purchasing the ailing Berkshire Hathaway (BRK.B) in the first place in the late 1960s. I for example own over 40 individual stocks. They are the best ideas I have accumulated over the past six - seven years of focusing exclusively on dividends. In a previous article I explained that researching stocks and keeping up with major developments doesn’t really take that much time. Once you learn the story behind a successful company, it does not take as much time to update your knowledge every year.

I have observed people with concentrated portfolios, and I have been able to classify them in two categories. The first category is those who are using “play money”. At the end of the day, I would never take an “expert” dividend investor seriously, if they do not have substantially most of their investable portfolio in dividend stocks. An investor who purchases some dividend stocks, while having the majority his/her investable assets in other vehicles, all the while claiming to be an expert is probably teaching you the wrong skills. After all, how can someone who does not actually plan to rely on dividend income for retirement teach you about dividend investing for retirement?

The second category consists of people who want to outperform the market, and believe that this is the easiest way to do so. These are the gamblers, who know that concentrating their portfolios in a few risky investments could pay off big time. Their goal is to generate some impressive track record in a short period of time, in order to sell investors their managed fund services. After all, if you find one company that would go up 100% in a period where the market is up only 10%, this looks pretty impressive. However, your portfolio results would be much better if you have 9 other stocks versus 29 other stocks in an equally weighted portfolio.

As a dividend investor, my goal is not to outperform the market but to generate a stable income stream that will proving a growing amount of income every year. That is why I invest most of my money in dividend growth stocks. I would not receive a pension, and I also plan on retiring much earlier than 55. As a result, safety of principle and income is as important to me as growing it over time. It would be stupid to risk my nest egg in an ego boosting exercise to prove that I can outperform the market. While I know that even the best researched top dividend stock can ultimately cut dividends in the future, my goal is to minimize this risk, while maximizing the potential of my income portfolio to grow distributions above the rate of inflation, all the while principal is safely growing as well.

Full Disclosure: Long RDS/B, CVX, COP, JNJ, MTB, BP,

Relevant Articles:

Why most dividend investors never succeed
Are performance comparisons to S&P 500 necessary for Dividend Growth Investors?
Dividends Offer an Instant Rebate on Your Purchase Price.
My Dividend Goals for 2014 and after
Generate Retirement Income with Dividend Stocks

11 comments:

  1. I just bought BP this week. I think it's time to get back in. Looks like the worst is over, and the dividend is very nice, over 4.6%.

    ReplyDelete
  2. BP is not too bad. I own almost all oil majors ( no TOT, because of the French W/H taxes). I bought BP back in Oct last year, and sold some puts also: http://www.dividendgrowthinvestor.com/2013/10/two-dividend-payers-i-recently.html

    I would say worst case scenario, you get to collect a 5% yield, which is not too bad. In a better case scenario, your dividend grows nicely, exceeds inflation and you live the nice life ( of course, the other components of your portfolio need to comply also)

    ReplyDelete
  3. This is a great sentence that turns off all the noise: "It would be stupid to risk my nest egg in an ego boosting exercise to prove that I can outperform the market."


    Best regards,

    ReplyDelete
    Replies
    1. I could not agree more with that sentence!. I have over 20 positions in my portfolio and sometimes DGI can be quite boring. Buffet would say better to be bored than worried but now, after much reading I have finally bought a pure growth bet: Prologis (PLD). My portfolio is quite conservative as I say and also completely DGI oriented (the usual suspects plus some spanish and european enterprises as I live in Spain) but I felt I was lacking some personal bet. Prologis is a REIT focused on industrial real state especialized on logistic premises with customers such as Amazon, and Tesco. It now yields 3.22% with a recent dividend rise and is growing fast. Any thoughts welcome. Keep the good job!

      My portfolio can be seen at http://www.dividendogma.com/?page_id=59

      Delete
    2. Hi Dividend Dogma,

      Would you mind sharing the names of some Spanish and European firms for DGI?

      Thank you

      Jean-Louis (Switzerland)

      Delete
  4. Great Article, and only too true when looking at my own portfolio ;). My excuse however is that I only recently started my venture into dividend investing, and I don't want to start buying stock for the sake of diversifying before I've had time to analyze the companies.

    Thanks for an enjoyable read.

    Best,

    DW

    ReplyDelete
  5. Fantastic article DGI. It really is difficult to avoid the temptation to believe you can pick a handful of shares that will do better than all the rest. Even more so if you've been lucky in the past with a couple of great investments - you'll start to feel invincible (as I did at one point - needless to say it didn't end well). And Buffett's diversification comments you mentioned can also be pretty dangerous if taken at face value. It's one thing for a highly experienced investor who isn't risking his retirement savings versus the average investor working hard to save every dollar they can, but regardless, even the most improbable events can happen at any time, to anyone, in the world of investing.

    It's fantastic that you have a very clear goal to generate a certain level of income from your investments, which no doubt helps you stay focused on your own plan. Keep up the good work!

    Cheers,

    Jason

    ReplyDelete
  6. I guess I am cocky. People should invest with strategies that work for them. But, for someone to insist that THEIR way is the BEST [re:least amount of risk] way is the true definition of cockiness. Something that works for me is following Buffett's ideas. Like the fact you are investing in businesses and should evaluate your investments as if you are buying a business. If a business has assets that produce revenue, is growing those assets, is well managed, those assets are in demand and are not easily competed against, and the price you are paying is fair, then you have the recipe for a good investment. I like the idea of receiving dividends, dividends that grow over time as the assets produce cash flow. I don't like the idea of getting dividend yields of 2-4%. There are enough good businesses I can invest in that provide higher dividend yields and growth with no more risk than average as long as I don't need to own 60 or 80 of them. Plus you should look at the math behind diversifying stocks. Not much to gain after 30. Very little gains after 10. So what it comes down to is that for you having 30-40-50 stocks in your portfolio, stocks that have a solid history of moderate dividends and growth, gives you the FEELING of less risk at the cost of a lot of yield. That is of course great for a retiree. But for us trying to build six figure dividend income without huge amounts of starting capital, the math doesn't work.

    ReplyDelete
    Replies
    1. Could you please substantiate your comment with the specific businesses you hold?

      Could you please also share with the rest of the readers the math behind diversification?

      Could you please also define what "risk" means to you? What is the definition of risk per this article.

      Last but not least, how much money are you investing? It is much easier to risk everything on 10 stocks when your portfolio is less than $100K. If your portfolio is in the hundreds of thousands of dollars, the cost/benefit of excessive risk taking is not there.

      Delete
  7. Very nice article I agree. I bought a huge portfolio of stocks during the last bear market. What I did is I just bought anything that was still alive. Recently I have sold out of many positions and bought several other stocks on recent dips after I read Get Rich with Dividends and found this site. Both have taught me how to research companies and I am very thankful. My first attempt at a portfolio was about to explode. Currently I have 15 healthy stocks and I have my eye on several more. Including V,HON,KMI,and CLX. Thank You again.

    ReplyDelete
  8. Entire portfolio: T, MO, BP, O. Just sitting back collecting the rewards (dividends). I don't really care what the share price does because won't be selling.

    ReplyDelete

Questions or comments? You can reach out to me at my website address name at gmail dot com.

Popular Posts