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,
- 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
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