One of the simplest truths about dividend growth investing is that not all companies you select will do as expected. Some will fail outright, while others will merely deliver some dividends which would barely match the rate of inflation. Based on studies I have performed, I have noticed that another small group of stocks will provide a large portion of returns in a dividend stock portfolio. You might not realize at the time of purchase, but the reality is that it is difficult to say in advance which company will do the best.
Even with those odds however, a dividend investor does not need to be right about all stock selections. In fact, even if they are correct for about 50% of the securities they pick, they should do fine as long as the dividend increases and capital gains from the winners offset the capital put to work in the “losers”. This of course is a very worst case scenario, since many of the “losers” will keep paying a slowly rising dividend, which could be spent or put to work into other dividend paying stocks. Therefore, I know that even by selecting my fair share of “losers”, I still have a very high chance of living off dividends. I follow a few principles to ensure I have the odds in my favor for a successful dividend investing.
This is why I stick to a few fundamental principles. The first principle is that I always strive to create a portfolio of dividend growth companies which are in one of the three types. The main goal is to be patient, and enjoy the ride. I view my portfolio like a a symphony. Each company in it has a role to play and together they make beautiful, income producing music. It is important to diversify risk with at least 30 – 40 securities, which will be purchased slowly and over time. Diversification helps when the proverbial bad apple takes a bite out of dividend income.
The second principle is to have patience. I have learned the hard way that once I purchase shares in a company I like and at a valuation I like, I should let it quietly do the compounding for me. I am a long-term investor, and my holding period is the next three decades. I am hopeful that my dividend portfolio will provide growing income for the next 30 years. This is why I need to view things in perspective, and think about longer term trends that span years, rather than get scared away from a single bad quarter or a single bad year. In the grand scheme of a 30 year investing time frame, one or two years are almost irrelevant data points. That doesn’t mean not to sell if there are any troubles brewing – it just means not to jump ship at the first “correction” or sign of “trouble”.
The third principle is being really selective about selling. After reviewing data about investor performance and psychology, I have come to believe that those who sell too quickly face reinvestment risk. Many investors tend to get a gain in a stock, see that the yield has gotten too low, and sell to get into a higher yielding security. As a result, they end up paying taxes, having less capital to invest, and in a large portion o the cases they end up with less in dividend income growth and capital gains than if they had patiently sat on their hands.
When you buy a stock, the worst think that can happen is that it can go to zero. The next thing that could happen is that you keep earning dividends, which reduce the amount you have at risk in the security, and then put those to work into more dividend paying stocks.
This is where the fourth principle lies in – hold on to your winners. The best case is that the company ends up performing like the next Wal-Mart (WMT), McDonald’s (MCD) or Coca-Cola (KO). You do not know at the time of purchase whether the company you picked will be profitable and paying more dividends in 30 years. You can make an educated guess, but the truth is you will not know which of your 40 stocks will be the best and which one will be the worst by 2044 – 2050. This is why I am trying to be as passive as possible, and reduce reinvestment risk as much as possible. I am often afraid that I will end up selling the next Coca-Cola (KO) to buy the next Jones Soda (JSDA), than missing out on the next Sigma-Aldrich (SIAL) because I stuck with Coke.
What I am trying to say is that with dividend stocks, your losses are limited, but your gains are unlimited and potentially much more than the amount you have at risk. This is why mistakes of omission, or the opportunity cost of not getting into a company prior to take off is a bigger problem than buying a bad stock. This is why I keep holding on to my winners, even if they end up delivering over 1000% profit.
Investors need to think probabilistically. In their portfolio of say 40 securities, there will be 10 which will likely do most of the heavy lifting for the next 30 – 40 years. If you sell those today, your portfolio will be mediocre. This is why it is also important to give companies a chance, provided you understand them well, they are available at a good price, and there are catalysts for future earnings growth. However, even for those who are average, it is helpful to understand that with each dividend check, the amount at risk in those securities is reduced. Therefore, even if in 2007 you had owned Bank of America for 20 years, you would have had received enough dividends to put in other dividend paying stocks that would almost cover for the capital you put to work initially
Full Disclosure: Long KO, WMT, MCD,
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