Monday, March 30, 2015

Comparing your results to S&P 500 could be dangerous for dividend investors

As a dividend growth investor, I tend to create diversified portfolios full of companies that regularly raise dividends. I try not to overpay for shares in these companies, when I put my money to work. Dividends are more stable than capital gains, which is what makes them ideal for those who want to live off their nest eggs. The end goal for me is to generate as much in dividends to pay for my regular expenses every month. I expect the forward dividend income generated in my taxable accounts to reach the dividend crossover point at some point around 2018. The stable nature of dividend income makes it easier provides much more confidence in projecting future dividend income at a certain point. On the other hand, I cannot tell you whether the value of the portfolio will be twice as much as today's or half as much.

However, I regularly receive some feedback from new readers, because they might have overheard about the importance of benchmarking against a common benchmark, such as the S&P 500. While I have tracked results versus S&P 500, I think that this is not a value added activity for my strategy and my goals. I believe that tracking my total return performance relative to S&P 500 is not going to add any actionable insights, that would help to me achieving my goals. My goals including reaching a certain target annual dividend income within a certain time period. Whether I do better or worse relative to some random benchmark is irrelevant to my long term goals and objectives.

I monitor the annual operating performance of the businesses I have invested in, as I review them at least once every 12 - 18 months. I also review press releases regarding quarterly results, dividend increases announcements, mergers and acquisitions. I track the organic dividend growth rate for my portfolio. I also track dividend income received, and try to understand whether growth came from organic dividend growth, dividend reinvestment and new cash contributions. As you can see, it doesn't matter for my goals and objectives, if over the next 5 - 10 - 15- 20 years the total return on my portfolio is better or worse than the S&P 500. Not only is relative performance versus a benchmark lacking actionable insights for me, but it could be downright dangerous for dividend investors like me.

The biggest danger in comparing my performance to that of the index, is reaching dangerous conclusions. For example, stock prices do not go up or down in a straight fashion. They move depending on a variety of factors, that few can predict in advance. Sometimes, even quality companies might be under appreciated by market participants, and their stock prices might stagnate for extended periods of time. At the same time stock prices can be increasing, as evidenced by stock indexes. However, if the fundamentals of the underlying businesses are doing well and improving, then holding on to those businesses might still make sense. This is because while their price is doing worse relative to the stock market index, they are getting more valuable, despite being underappreciated by the stock market. It might take the quoted price some time before investors realize this discrepancy and bid up the price. If I sold undervalued shares, to buy something that has done well in price, I would be selling low and buying high. I believe that this is not smart investment behavior. Please remember that the stock market is there to serve you, not to instruct you. The time to sell a business is when it no longer performs to expectations, not because the stock prices a group of other businesses have done better in the past 3 - 6 months.

For example, back in 1999 - 2000, many shares of tobacco companies, financials, utilities and REITs were punished by investors who wanted new economy technology companies. The popular indexes such as S&P 500 and Dow Jones Industrial's Average added technology companies in 1999 - 2000. The performance of those companies was great for a while, as everyone gobbled up those shares in speculative frenzy. The old economy boring companies were not viewed as attractive enough. If a dividend investor had sold their tried and true investments because they underperformed for a short period of time, they would have made a terrible mistake.

If I am impatient however, I would feel like I am missing out by comparing my “slow moving” stocks to the index and chances are I would sell as a result of the exercise. This is usually at the same time that the index would likely start dragging its feet, while the shares of the former “slow mover” finally get appreciation by buyers. I see this happen again and again. This is why most individual investors never make any money in stocks – they go from one strategy to the next, chasing hot strategies and looking for something that magically works all the time. If they stick to a slow and steady strategy like dividend growth investing, they would do very well for themselves over time. This is because rising earnings per share, leads to rising dividends per share, which ultimately makes stock prices more valuable. Plus, the fact that most dividend investors are truly passive, they can compound their capital for decades investing in what they know. Studies have shown that the more passive the investor, the higher the chances for satisfactory long-term performance.

My goal should be to have a portfolio that produces slow and steady returns that I can live off of. If I get scared because my portfolio underperforms for a few years, and I end up switching at the worst possible time, I would likely never make any money investing in stocks. The real lesson here is to have a solid understanding behind my strategy, and then to have the patience to stick to it through thick and thin. If I sold my dividend portfolio holdings today and I invest everything in an S&P 500 fund, my dividend income will drop by 45 - 50%. This will be caused by the fact that I will have to pay capital gains taxes on unrealized capital gains and I will have to accept a lower current yield. This change would actually require me to spend more time working at a job that I might or might not enjoy. Since I am not a robot, I have a limited number of years on this earth that I can spend working, rather than enjoying life. In addition, index funds contain a lot of companies that do not pay dividends. And as we know, relying on capital gains works great during a bull market and prices move up. However, if prices are flat, as they were between 1929 - 1953 or 1966 - 1982 or 2000 - 2012, my portfolio will not last for long if it doesn't yield anything. Selling off stocks in your portfolio results in less stocks available over time. If prices do not grow fast enough, you will deplete your portfolio. Selling off chunks of my portfolio to live off is similar to cutting the tree branch you are sitting on. Why not just pick the fruit from the tree, and let it grow uninterrupted?

The problem with indexing is that there is no one-size fits all approach. Some index investors allocate 100% of their money to US stocks, others split it between US and international, while a third also add as much as 50% in fixed income. Each of those three types of portfolios will have different expected returns. In addition, the relative weights for large-cap versus mid-cap versus small-cap shares could affect expected returns as well. If you dig into international stocks as well, you have to decide between developed, developing, frontier, and then deep dive into large cap, small cap, mid-cap and growth versus value. The expected returns of each of those index investors will vary significantly. In reality,the past 8 years have been good for the dividend growth investor who is entirely in stocks. This not only includes the S&P 500 but also commonly used index portfolios where stocks and bonds are equally split, and re-balanced periodically. By investing mostly in US stocks in my taxable portfolios, I have done better than most index portfolio that held bonds or international stocks. I would expect that in the next 30 years, a portfolio of dividend growth stocks will do better than the typical index portfolio that holds 50% – 60% allocation to stock indexes, and a 40% - 50% allocation to fixed income.

When someone tells me they are going to sell securities from their portfolio, they are essentially telling you that they blindly believe the stock market will only go up during their retirement. This flawed thinking ignores past history, and sequence of return risks in the portfolio distribution phase. It also resembles the flawed belief by some homeowners between 2000 - 2008 that they can tap equity from their appreciating homes and spend the proceeds. Treating your house like a piggy bank, and relying on increases in house prices to live off turned out to be a poor choice. Spending too much time comparing yourself to the Joneses, is another folly people do. To me, comparing total returns of my portfolio relative to that of someone else's is a perfect example of keeping up with the Joneses. This can only lead to folly behavior.

I am not a big fan of dividend funds or dividend ETF's either. Even dividend growth funds tend to do bizarre things such as keep companies that have cut dividends for almost an year, as was the case of Citigroup in 2008. Another bizarre thing I have seen is when some companies are not included, or others are taken out, as was the case of Altria (MO) being dropped from the S&P Dividend Aristocrats index in 2007. A third example includes my purchase of Higham Institution for Savings (HIFS) in 2010, which was not covered anywhere else except on the list provided by David Fish.  As you can see, indexing does not work for my goals and objectives. However, it could still work for anyone else. Because I am the only one who truly cares about reaching my own goals and objectives, I create my own portfolios by picking individual stocks.

To reiterate the biggest danger in comparing to index funds is that any under or over performance produces no actionable insight for my portfolio management. On the contrary, it can cause me to abandon my strategy at the worst time possible, simply because I “underperformed” the index. With dividend growth investing, I would likely at least match total returns of S&P 500 over long periods of time like 20 years for example. This could include variations in under or over performance over periods of time of varying lengths. However, just because I underperformed for 3 years, it doesn’t mean I would underperform for next 3 years. Because of reversion to the mean, the 3rd year of underperformance might mean that dividend stocks are cheaper than the stock market as a whole. Therefore, they could provide much better returns for the next few years, relative to a market index such as the S&P 500. As usual, past performance is not a predictor of future performance.

The real reason why everyone encourages individual investors to buy index funds in the first place is because some individual investors are horrible at making investment decisions. Not only are they terrible at investing, but they are overconfident and overtrade, fail to stick to a single strategy because they are afraid of missing out on the next big thing. The common fallacy among inexperienced investors is that you need to find the next Microsoft to make money in stocks. Unfortunately, few ever find the next Microsoft, but many lose a lot of money in the process. In fact, these investors would have been better off simply buying and holding on to the original Microsoft in the first place.

(The conclusion that individual investors are terrible at investing is based on data I have analyzed from DALBAR. While I am sure DALBAR is a reputable organization, I have learned to always take information with a grain salt and some healthy dose of skepticism. This is because the information is used by financial providers, advisers and mutual fund companies in order to get clients. Since Dalbar's clients are financial services companies, DALBAR has an incentive to show how bad individual investors do on their own.  If you prove to investors that they need help from the financial industry, they are more likely to come and earn money for your company. There is an incentive for DALBAR to not compare apples to apples, in order to make a case against individual investors. So, as Charlie Munger says, "Never ask a barber if you need a haircut" )

The truth is that if you build a diversified income producing portfolio with companies that are purchased at fair prices, and you do little activity every year, you stand a chance to do pretty well over time.

I reached these conclusions after studying the performance of the original 500 stocks in S&P 500 in 1957 versus index, as well as the ING Corporate Leaders fund for the past 50 years. Did you know that S&P 500 index replaces approximately 4% of components every year? Did you also know that if you had purchased the original 500 components of the index in 1957, and held on for the next 50 years without doing anything other than reinvesting your dividends, you would have outperformed the index? Did you also know that S&P 500 frequently makes changes to its index methodology, which would have reduced past performance numbers?

In addition, if you study the history of the ING Corporate Leaders fund, you can gain a glimpse of the potential in a truly passive buy and hold portfolio. The trust was formed in 1935 with a list of 30 blue chip dividend paying stocks. Given the mergers, acquisitions, dividend eliminations, the list is now down to 22 companies. Over the past 50 years, the fund has managed to return 10.20%/year, versus 9.80% for the S&P 500. The trust sells when a company eliminates dividends or stock price falls below $1.

To summarize, it looks as if the only way to achieve my goals and objectives is by constructing portfolio myself, by purchasing companies with sustainable advantages at fair prices, and then holding passively for the long run. Being passive should be the goal, as selling is usually one of the biggest mistakes investors make. It is a mistake because few can just sit tight and enjoy the ride while ignoring the noise out there. Frequent churn could be costly. Cutting investment costs to the bone is also very very important. If you have a $1 million portfolio invested in index funds, you are likely paying $500 - $1000 every year. You can easily purchase stakes in 30 – 40 of the largest dividend paying blue chips listed in America, and just hold them for eternity. Some of those will fail in the next 40 - 50 years, others will merge or be acquired or spin off countless subsidiaries. A third group would likely still be around 40 – 50 years later, showering you and your descendants with more dividend income than you ever imagined in your wildest dreams.

Update: I have received a tremendous amount of hate mail from index investors related to this article. One index investor just wished me that my portfolio goes to zero. I wonder if they realize that their wish means S&P 500 will also go to zero.

Full Disclosure: Long MO, HIFS

Relevant Articles:

Dividends versus Homemade Dividends
Why I am a dividend growth investor?
Dividend Portfolios – concentrate or diversify?
Are performance comparisons to S&P 500 necessary for Dividend Growth Investors?
How to be a successful dividend investor

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