Wednesday, March 4, 2015

Dividend Investing Knowledge Accumulates Like Compound Interest

Dividend investing is highly scalable. This means that the knowledge of how to screen for, analyze companies, and build dividend portfolios is relevant whether someone has to put $10,000 or put $10 million in stocks today. I am also not paying any management fees to someone who simply assembles a portfolio of a random number of companies, but charges me money each year for the privilege of holding several hundred well-known blue chip stocks.

I believe that my effort in gaining knowledge about businesses, which I have accumulated over the past 1.5 - 2 decades has been a good foundation that will pay dividends for hopefully 3 - 4 more decades in the future. Learning about business, stocks, asset classes, valuation, economics, and continuously acquiring company or investing specific information will pay dividends for decades down the road. I believe that the ideas I obtain from different sources, tend to build on existing knowledge, which will again pay dividends for years. This is why I believe that knowledge accumulates like compound interest over time.

Dividend investing works for me, because it is very easy to construct a portfolio that generates a certain amount of income, and match that to my expenses. My goal is to live off my portfolio during bull and bear markets or recessions and economic recoveries. That goal is much easier to accomplish when I live off dividend income. This is because if I relied on traditional asset depletion strategies like the four percent rule, I would risk selling off the stocks or funds in my portfolio during a protracted bear market or flat period for stock prices. This could increase the risk of running out of money, since I will be selling low, and reducing the amount of assets I own. This to me sounds contrary to common sense. I would much rather accumulate cash producing assets,spend the cash they generate, and keep the assets. The asset producing assets for me are dividend growth stocks, but if you don’t know about stocks, you can do it with farmland, real estate in college towns, etc

With dividend investing, I have high certainty on the amount and timing of dividend income I can expect each month, quarter and year. This makes living off my portfolio a breeze, and would be similar to the cycle of regular paychecks one is accustomed to in their workplace. I want to generate cash every month or quarter to live off of, and not have to worry whether the market is up or down, so that I don’t sell my assets at low prices.

I like learning about businesses, learning about companies, and expanding my horizons. I believe in life-long learning. I also know that the knowledge I gain from researching investments has given me the knowledge to stand out from other candidates whenever I have been looking for jobs in the past.

If you are not interested in learning about business, then index funds might be the best bet for you. If you don’t have time for managing investments, then index funds might be for you. However, I can only talk about what I do with my money, and not provide individual investment advice. I would never myself invest in anything, without researching it really well. Only then would I decide whether this investment fits my goals and objectives. If I had no knowledge of investing, I would never put money in mutual funds or index funds. It is very likely that I would not own any stocks. Period. This is because I might do the right thing for years by patiently putting money in funds, and then one day I might hear that the economy is bad and how everything is going down. For someone who has absolutely no knowledge of investments, and who has not done their homework, it would be very easy to panic, and sell at the worst time possible. If someone also doesn't know much about investing, they also risk falling prey to unscrupulous financial advisers who sell expensive products like annuities or loaded or high expense funds.

Someone who is told to buy index funds, but doesn't understand why to buy them, is actually done a disservice. There are no shortcuts to investing, and index investing is not a magic panacea. If you want to live off a portfolio, and the stock market is flat for 16 years, index funds would not save someone’s nest egg after 16 years. In 2008 – 2010, many investors I spoke to were telling how bad stock index funds fared, since they had essentially generated very poor returns in the preceding decade. For someone who retired in 2000, they now have less than half of their money left and only a few years worth of expenses left. In my previous job, I had someone who retired in early 2013. He was not very optimistic about the fact that S&P 500 had reached record territory. The reason was that he had seen the stock market stay largely flat for the preceding 13 - 14 years. This is a lifetime, relative to the average amount of years we put working. This individual used to believe that stocks always go up and should deliver 9% - 10%/year. Unfortunately, the stock market proved that it is indeed a manic-depressive individual, whose goal is to confuse as many people as possible. That's why a strategy that relies on increasing of stock prices is not really taking into account the unpredictable nature of stock price fluctuations. As a dividend investor, one can ignore stock price fluctuations, since I am living entirely off the cash distributed from profitable enterprises, not by selling pieces of business that might go up or down in value.

Indexes are also teaching investors poor behavior such as ignoring valuation. Someone needs to learn about valuation before placing their hard earned money to work. In addition, if someone is a bad investor, they will find a way to lose money, even with the bullett-proof index funds. For example, investors in the Vanguard S&P 500 mutual fund have underperformed the S&P 500 index by 2.50%/year over the past 15 years. If you do not believe me, check this page from Morningstar.

I actually think that if everyone wants to be an indexer that could create a lot of inefficiencies, and could make indexing not as robust as it has historically been. It could also create opportunities for non-indexers. Of course, for those who have the ability to stick to a strategy for 20 - 25 years, it wouldn't really matter whether someone else picked 500 stocks for them, or whether they hand-picked 40 - 50 companies themselves. The caveat is that paying too much for future earning streams could result in much lower returns than in the past. The hand-crafted portfolio stands a better chance in the entry valuation camp.

ETFs are also notorious for their fluctuating distributions, much worse than those on S&P 500. This is because of frequent turnover, and building portfolios without trying to generate stable and growing distribution stream for shareholders. Rules of inclusions in different indexes are very arbitrary as well. For example, the S&P Dividend Aristocrats Index removed Altria (MO) in 2008, after the spin-off of Phillip Morris Internatinal (PM) and Kraft Foods (KRFT). This was a dumb move on their behalf, because Altria did not cut dividends. The dividend seemed lower, mostly because the company had split into three. But the original Altria Group shareholders enjoyed rising dividend income streams in the subsequent years. Unfortunately the S&P committee did a bad job in actually understanding the situation. Rather, they chose to mechanically remove a company whose board of directors had regularly increased distributions every year for close to 4 decades. And luckily for those like myself, who never sold Altria, those boards have kept raising dividends every year.

As you can see, you can learn from any strategy. For example, index investors naively believe that an index such as S&P 500 is "passive". This passive nature of indexing is the main selling point, since it has been documented by academics that individual investors as a group tend to do poorly particularly due to turnover. In reality, the S&P 500 index (which is the most popular vehicle for index investors) experiences turnover each year. According to research by Jeremy Siegel, this turnover has slightly reduced returns for investors. Thus, it pays to hold on to your companies as long as possible. This is why I have held on to Abbvie (ABBV), Abbott (ABT), Kraft (KRFT), Mondelez (MDLZ) etc. It is also one of the reasons why I hold on to companies that have kept dividends unchanged or those that experience temporary setbacks. In fact, when I analyze my results, and the results of other bloggers who publicly disclose their investments, I have noticed that selling is usually a bad idea in 80% of situations. Patience is the main edge I have against Wall Street.

At the end of the day, the goal is to create a portfolio that realistically matches someone’s needs. I say realistically, because if you need $40,000/year to live off for the next 30 years, but you only have $400,000 in your portfolio chances are that you are not ready to retire. However, if you need $12,000 - $16,000 in annual income, that has a high chance of at the very worst maintaining purchasing power over time, there is a high chance that a hand-built portfolio of dividend stocks could do the trick. It shouldn’t matter if you underperform index funds or not, as long as someone is achieving their goals.

In addition, for single people making less than $47,050/year or for Married people making less than $94,100/year, qualified dividend income is essentially tax-free at the Federal level, if that’s the only type of taxable income they earn. Hence, the argument against dividends that they are inefficient, and result in double taxation of income is not really valid for those individuals. Learning about taxation of dividends, and learning about taxation in general, has definitely made my life much easier, and has helped get my whole financial house in a much better order. I do believe that knowledge is power, that provides me with options in life. The more options I eventually have, the better the chances that I may be able to live it on my own terms. And that’s what financial freedom means to me.

Full Disclosure: Long PM, MO, KRFT, MDLZ, ABBV, ABT,

Relevant Articles:

Why am I a dividend growth investor?
Dividend investing for monthly income
My Retirement Strategy for Tax-Free Income
Dividends Provide a Tax-Efficient Form of Income
Dividend income is more stable than capital gains

9 comments:

  1. Excellent article DGI ! You present a good case for living off dividends, which my wife and I are currently doing... :-) Thanks, Rog

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  2. DGI,

    I like how you explained the concept of really not caring about stock prices in the long run. For those of us who are building a portfolio with the intention of living off the interest or dividends generated from that portfolio, stock prices don't matter as much as the rising stream of income and the rate at which that income grows. The idea of having a SWR honestly scares me for exactly the reason you described, you will suddenly sell more of your income producing assets during a bear market when you really should be doing the opposite, accumulating income generating assets at a discount. This is most likely easier said than done, I guess I'll find out as I'm only 22 at the moment so I don't know how I will actually respond during the next downturn.

    I also like that you said its not necessary to compare one's portfolio to a certain benchmark due to each investors individual goals and objectives. Best of luck to reaching financial independence!

    Regards,
    Dividend Odyssey

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  3. Your thinking is right but for the majority of people they just don't find investing or taxes that exciting. That is unfortunate since keeping your money should be the top priority of every citizen.

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  4. Excellent post. Lifelong learning is indeed a light and powerful tool to take with your on your journey through life. Avoiding market price fluctuations and simply living of a rising stream of dividends is ideal. Now as you mentioned it is certainly not for everyone and I would argue the vast majority do not have time interest or knowledge to select and research individual equities therefore are better off with a broad market low cost index fund. With respect to s&p500 the actual tracking error is a lot less than the 250 basis point a year you mention. I believe the dichotomy is from comparing investment return vs investor return. Someone who simply bought and held would be closer to the index with maybe a 25 basis pt difference over the decade. Full disclosure long PM as well.

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  5. If you follow the link you provided to Morningstar and then go to the fund performance, you will see the 15 year total return for the fund is 4.60% versus 4.71% for the index. I think the 250 basis underperformance you cite is for an average investor, not the fund itself. You should compare that to the hypothetical average dividend investor is such a measurement exists. Further, dividend investing strategies are more akin to value investing. Maybe you should be using a value index as a benchmark.

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  6. Now that's the type of posts I like! :-) I think many investors stop the learning process after a while because they think they've figured it all out... Big fail to me! Everything is up there to evolute, change and learn from. That is why I'm always curious and excited into discovering strategies different than mine.

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  7. Love this article and your comparison between index investing and dividend investing. Lifelong learning is very important.

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  8. Consider an evaluation of ARLP or AHGP since coal is not going away anytime soon. In value territory now.

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  9. Very interesting post. Learning should never stop!

    BSR

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