Wednesday, September 26, 2012

The most challenging aspect of dividend investing

Many dividend investors focus exclusively on finding the best dividend stocks. They spend countless hours analyzing companies, studying balance sheets and perfecting their entry criteria. Yet, when the companies that have taken so painstakingly to identify and research appreciate in price, investors decide to cash in and move onto the next idea. Unfortunately in most situations, investors end up worse off in the new idea, in comparison to just sitting tight and doing nothing.

I am always fascinated that investors who are quick to pull the trigger on gains they generate, freeze to death when the stocks cut or eliminate distributions. They become hopeful, when they should be fearful of losing their nest eggs. These investors end up hoping and praying that one day their dividend income will breakeven, meaning that they will generate as much income as when they originally made the investment.

These examples appear to be black and white, and too rigid. If investing has taught me anything, it is that things always change and that one has to remain flexible in their approach. Yet, one recurring pattern in my investment portfolio that I have noticed is that winners tend to keep winning, yet losers tend to keep on losing. In the world of dividend investing I have found that companies like the constituents of the dividend achievers list have a very high probability of continuing their streak of consistent dividend increases. I have also found that companies which cut or eliminate distributions are seldom good investments for the long term investor, even if they eventually decide to regain their dividend growth stock status.

What I am attempting to describe here is the fact that dividend investing is very difficult. It is not difficult because analyzing balance sheets, moats and business models is that hard. It is difficult, because a large component of the investment equation deals with investor psychology. Even if investors are shrewd enough to have selected the best dividend stocks in the world at the right price, they could still end up not making any money, or even worse – losing money.

Investors who purchased at the right price can do no wrong by simply holding onto the rising income stream, as long as the distribution is not cut or eliminated. The dividend trend should be their friend. Unfortunately, psychologically speaking, it is very difficult to hold onto a winning position. A position that goes up 50%, 100%, 200% and even more over a period ranging from a few months to a few years or even decades would make most investors want to ring the cash register. This would be the case even if the underlying fundamentals are still intact, and bullish trend in earnings and dividend payments is expected to continue onto the future.

Another psychological problem that dividend investing poses is that it is a slow process of building wealth and passive income. For many, it would take anywhere from one decade to several decades. Few investors have the tenacity to forgo current consumption and stick to a single investment strategy for years. People tend to give up easily when confronted with certain tasks where the payout is a long time away. It is very difficult to compare your long-term approach to dividend investing to the get rich quick mentality of most other investors, who might have made quick gains in volatile technology stocks over the past year. Investors who decide to take shortcuts to achieve their target dividend income, might end up being disappointed in the process. Some shortcuts include taking excessive leverage that could lead to huge investment losses even during a small market correction, or using options and futures without understanding them completely. Another shortcut could include loading up on high-yielding companies such as mortgage REITs like American Capital Agency (AGNC) or Annaly Capital (NLY). If short term interest rates start increasing faster than longer term interest rates, the distributions that these mortgage REITs pay would be in big jeopardy.

The psychological dilemma of successful dividend investing is evident for situations where investors have purchased companies that have raised dividends for a certain number of years, and when they keep raising them in the future. Many investors have been taught at school or at their jobs that inactivity does not result in payoff. As a result, many end up selling winners, paying capital gains taxes on the proceeds and limiting their upside this way. Unfortunately, successful dividend investing is sometimes counterintuitive to this way of thinking, since it is all about being right and maximizing this to the fullest extent possible, even if it takes several decades of positive reinforcement.

Relevant Articles:

Dividend Investing is not a black or white process
Accumulating Dividend Stocks is a Long Term Process
How long does it take to manage a dividend portfolio?
The Most Successful Dividend Investors of all time


  1. Why do you insist that one needs to remain flexible in their approach, but advise them against selling when their investment appreciates 200%?

    I assume you argue against it because the yield on cost after a long period is at its highest for your typical aristocrat stock. To sell it and buy another is sacrificing that excellent yield on cost, which has taken years if not decades to achieve.

    But what if that price appreciation hasn't taken years, but months? Seems to me you should take the profits-- which amounts to years of dividend payouts-- and find the next great value aristocrat.

    Young investors especially might sell a portion and invest the profits to diversify their portfolio.

  2. How do you feel about BLK and AVG as additions to a dividend portfolio?

  3. I think one factor that contributes to building a long term investor mind while investing in dividend stocks is to actively monitor one's portfolio. Short term tasks help to strengthen a long term view.

    To me, one of the most rewarding psychological aspect is to monitor pay dates of the dividend stocks that I own. I use iCal on my Mac to keep track of pay dates, and I obviously keep an Excel worksheet where I track my investment and dividends on a monthly basis. I automatically reinvest dividends for some of the securities, and seeing the number of shares grow quarter after quarter is very rewarding - psychologically speaking. More shares, increased dividends, more money at the end. This way, I feel like doing something, even though I don't sell anything. My shares of KO and PG may very well still be in my portfolio when I'll be dead decades from now.

  4. If it takes more than a decade to create a decent portfolio then it is a long wait. I think persistence is the main winner here.

  5. Well said. To paraphrase the immortal words of Benjamin Graham, "in the short run stock prices are a voting machine, but in the long run it is a weighing machine." It takes discipline to avoid the temptation to over manage a successful portfolio. --wj

  6. I've grown more and more agreeable to dividend investing as I've gotten older and accumulated more capital. This is a great way to establish a core portfolio. What you always seem to leave out are some of the more aggressive strategies that can be applied along with a good dividend portfolio. Personally, I like to sell covered calls on my stocks and naked puts on my cash, considering cash to be of my portfolio holdings. I also like to buy options with a small portion of my account. These strategies take a little more work than simply holding dividend stocks forever, but they can add a lot to the accounts return for a little additional work and a small additional risk.


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