Wednesday, May 27, 2015

Simple Investing Principles to Follow

I have been overdosing on everything about Warren Buffett in the past two-three years. This has spilled over to learning more about Warren’s business partner Charlie Munger. Charlie Munger is big on the so called mental models, which are principles on how to live your life.

In this article, I have outlined several simple principles on investing, which I think should be the foundation of your investment strategy, whether you are a dividend investor or choose to do something entirely different.

The first concept you want to understand is the power of compounding. Compounding is the process where you earn money on the money you invested a certain amount of time ago. You start with an initial amount and have a certain rate of return, and you reinvest gains and dividends back into your portfolio. As a result, you are exponentially increasing your net worth and income.

The second simple principle to take into account is that over the past 200 years, the US stock market has been going up almost every decade. This is a phenomenon not just limited to the US however. A study of most other countries show that equities outperform all other assets over time. This is because stocks represent ownership of real businesses, which over time have more consumers, raise prices, bring new products and gain efficiencies and know-how on how to do things better, cheaper and faster. Reinvested earnings drive growth in the businesses, while reinvested dividends compound your net worth and income even faster. While there are occasional blips that could last for years, equities should be the main cornerstone behind your investment strategy. These occasional declines in share prices, no matter how severe, should not scare the individual investor. On the contrary, they should be seen as opportunities to acquire more equity interests in quality companies at discounted prices.

The third principle to remember is that stocks represent partnership interests in real businesses.  Stocks are not just some blips on a computer screen. While investor sentiment drives stock prices in the short-run, underlying fundamentals drive whether you are going to make or lose money from your investment in the long-run. Over time, growing earnings, dividends make businesses more valuable, hence you will see 52 week highs and all-time highs most of the time. As a result, as a part-owner in a business, your goal is to determine whether the business can earn more money over time. The rise in stock price and dividend will follow if earnings increase.

The fourth principle is diversification. It is important to realize that things can happen to a business that cannot be even considered as a problem today. If you spread your capital in at least 30 – 40 businesses over your lifetime, you would do just fine in the long-run, while protecting your principle in the process. Having exposure to different industries, countries is a must in protecting investment capital from the destructive forces of time.

The fifth principle you need to take in consideration is that increasing investment activity is bad for your returns. The goal of the investor should be to buy or create an equity portfolio, and then sit on it for decades. If you try to time the market by trying to sell at what looks like a top, and try to buy at what looks like a bottom, you might be unable to achieve your investment goals and objectives. In fact, studies have shown that increased levels of activity among individual investors are correlated with extremely low returns relative to their benchmark. In addition, did you know that if you had simply purchased the original 500 components of S&P 500 in 1957, and then did nothing for the next 50 years, you would have outperformed the S&P 500? Therefore, if a company you own spins-off a subsidiary, just hold on to the stock. From a tax efficiency perspective, you should do just fine.

The sixth important principle to ingrain in your memory is to be unemotional about your investments as much as possible. Most investors are terrible at investing, because they lack the emotional characteristics associated with dealing with rising and falling prices. They get excited when stock prices have been rising for a long period of time, but get depressed when stock prices start going down. These investors are always afraid that they are missing out, which is why they frequently change strategies to chase the next hot fad. You should not let emotions run your investments. The successful investor should have a plan, and stick to it through thick and thin. The best plan is to buy, hold and occasionally monitor your portfolio. Remember, it is time in the market that can lead to success, not timing the market.

Another important principal to remember is that entry price does matter. For dividend investors who focus on selecting individual stocks, there are always some attractively valued opportunities available. There were quality companies available at fair prices during the 1972 Nifty-Fifty Bubble, and the 1996 – 2000 Technology Bubble to name a few. Dearly overpaying even for the best companies is a mistake. This is because your initial dividend yield will be ridiculously low, and the price you paid would have all the growth for the next decade already baked into it. In the case of Coca-Cola and Wal-Mart investors, who overpaid in 1999 – 2000, earned low returns over the subsequent decade. This was despite the fact that the underlying businesses produced stellar operating results during the same time period. In addition, one should focus on the current and future ability of the business to generate profits, and not focus on profits that were generated 5 or 10 years ago. In the case of the Nifty-Fifty, the companies generated returns close to that of a stock market index. Of course, investors would have had to patiently hold for a quarter of a century in order to obtain this result. This was difficult, because the first decade was characterized with heavy losses that were more severe than losses experienced by blue chips stocks as a whole.

Relevant Articles:

Buy and hold dividend investing is not dead
Fixed Income for dividend investors
The Pareto Principle in dividend investing
Why dividend investors should never touch principal
Dividend Portfolios – concentrate or diversify?

19 comments:

  1. Nice punchy reminder of some of the basic principles everyone should remain aware of!

    For me, the first real test of some of these will come when the next market crisis occurs (I was largely uninvested when the first hit, except in Tesco). At present I seem more than able to handle paper losses without panic! But, of course, to see every one of your investments showing a loss would be a different beast!

    Currently, I am woefully undiversified geographically being almost exclusively UK-focused. This is something I would slowly but surely like to correct because, as you note, it does make a difference over the long term! I just have to find the best way to do it!

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    1. Knowing that it is likely to have a quotational loss of 20 - 30% once/twice a decade is one thing - experiencing it is quite another. It is scary to see your networth drop

      However, as long as you are gainfully employed, this is the time to keep dollar cost averaging unemotionally. As for diversification, I am not sure about UK, but most US Blue Chips derive significant amounts of revenues internationally. In this globalized day and age, where a company is headquartered doesn't matter as much as the industry it is in, and the places it derives revenues from.

      Best Regards,

      DGI

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  2. "These occasional declines in share prices, no matter how severe, should not scare the individual investor. On the contrary, they should be seen as opportunities to acquire more equity interests in quality companies at discounted prices."

    That is true for someone who is currently working, but may not be possible for a retiree living on the dividends from his/her investments. It depends on whether or not your dividends cover all of your expenses, or if you generate an excess that can be reinvested. It can be more difficult from a psychological perspective for retirees versus those still employed. Otherwise, even as a retiree I agree with everything you wrote.

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    1. Correct me if I'm wrong, but dividends are a fixed dollar amount, not a percentage of the stock price (although they are reported as a %). Thus if your stocks drop 10% or even 20%, as long as the company does not cut the dividend payout, you will still receive the same amount of dividend income as you had before. DGI has mentioned often that a cut in the dividend is a strong sell indicator, but even a stable dividend during bear markets would continue to generate the same income no matter how low stock prices drop.

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    2. KeithX,

      Yes, but the goal of the retiree is to live off their nest egg, not to build up their nest egg. Once I reach my target income, will have won so I would not put as much emphasis on growing the dough. If there is surplus left over at the end of the month/quarter/year, it will provide capital to invest more. A retiree during a bear market can simply collect the dividends, keep monitoring and enjoy their golden years. Funny how you left your comment about retirees, yet you are retired, but still make purchases of dividend paying stocks.

      Good luck!

      DGI

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    3. Hi Peter,

      You are correct that as long as the dividend is stable and growing, the retiree should not be as worried as the retiree which will have to sell assets regularly to fund their expenses. I would have hated having to sell my shares at rock bottom prices if I were retired and if I had to sell shares every month from 2000 - 2003 and 2007 - 2009.

      And yes, having an exit plan is important too - a dividend cut is more like the last resort of proof that things are as bad as they seem at the company level. Monitoring investments is an important part of the process.

      Best Regards,

      DGI

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  3. Hi DGI,

    Thanks for the post. Definitely a loot of good principles in here that I'm glad to be reminded of. Especially concerning equities and how they go up over time without fail as they do represent businesses, and aren't just numbers on the screen and certificates of ownership in your hand!

    Best Regards,
    DB

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    1. Businesses do eventually recover if you allow them time and you do not panic, and you keep reinvesting those dividends. However, it is also likely that periods of poor returns are followed by periods of good returns. This is why it is important to avoid overpaying and selecting quality companies which stand a chance of paying and raising dividends when things get tough.

      Best Regards,

      DGI

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  4. Great summary, simple principles but not always so simple to follow. Your 3rd concept is why I now like to say "investing in companies" rather than "buying stocks" to really confirm what I am doing =)

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    1. I love simple ideas, which are packed with insight and actionable content. Compound interest is the cornerstone of any investment strategy out there. You sre correct that stocks are ownership pieces of actual businesses. Over a period of 20 - 30 years, a large part of return will be dependent on how the business does and what valuation you entered it at. In our instant gratification culture today however, most look at stocks like a gambler approaches the casino floor in Vegas.

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  5. Thanks DGI ! Wonderful principles to invest by...

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  6. the 2008 crash caused even great business models to stop or reduce divis had I sold my 1400 shares of wells fargo at the time I would of lost out big time. But I knew that company well enough to stay put actually invested more near the lows to reduce my cost per share by 10.00 .

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    1. Actually, the dividend cuts were concentrated in the financial sector in the US. Anywhere else you look, in other sectors, dividends went up. This is why it is important to be diversified, but also to hold quality.

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  7. Great article DGI. I like how you mention taxes and history. People have asked me why I think dividends are taxed at a lower percentage. Some have called it stupid, some have thought they were taxed at a higher percentage as well. I told them all the same thing; who makes the rules? People in Congress, and their ears are bent towards those with the deepest pockets. Those people typically are the Congresspeople or CEOs of districts, and naturally they want to protect their dividends as they happen to be their largest income generators. Its foolish for average people to miss that boat as well, just like it is careless to invest with lots of emotion.

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    1. There is research that states that one is as good as the five people you interact with the most. In my everyday life, I try to interact with people who are better than me, so that I try to improve. I have had friends which have always tried to put down my ideas, and do not really add value to me - So I have been phasing those out. At some point, people that do not get simple problems might end up being a drag on you ( unless of course they provide some other intangible benefit)

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  8. Great stuff to always keep in mind.

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  9. We have all been scared a couple times! ;-) The theory is good, but it is sometimes a great challenge to really take emotions out of investing. Experience makes us better for sure! Thank's for the reminder!

    Cheers,

    Mike

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