Wednesday, July 15, 2015

The biggest investing sin exposed - part II

In part one, I started talking about the biggest investing sin exposed. This is part two of the series.

My sample of three is not representative at all. These are individuals I have found through my browsing of the internet. If these individuals stick to their new found strategy for the next 20 - 30 years, I believe they will have high odds of succeeding. If they switch strategies however, I would be worried for them.

JLCollins – After reading his investment history, it looks like he jumped from strategy to strategy, selling everything in 1987, getting back in 1989, chasing hot funds like CGM Focus, then admits to chasing dividend stocks. I was surprised how much turnover he had in a single year, when he essentially sold 25% of his portfolio that was in REITs and bought a stock index fund with the proceeds. He is mostly in US stocks, with approximately 20% in fixed income. I think he invested without a clear strategy between 1974 and 2011, before embracing indexing. Since he has only used indexing during a bull market, I wonder whether he will make a switch in strategies again.

Boomer & Echo –This blogger sold all dividend paying stocks in 2014. Didn’t mention how much hit the capital gains taxes were. Seems to switch retirement goals/objectives all the time and extends them further. Latest post shows he expects a 6% withdrawal rate in retirement, which is unsustainable. The reasoning behind using index funds was full of logical flaws and shows he doesn’t’ know how to compare apples to apples. It looks like he chose indexing because he has unreasonable expectations, and thinks that a 3-4% dividend yield is too low for him to live off. The real problem is their savings rate. The sad thing is this person is advising others, so I would be scared if I were his client and he told me to withdraw 6% of my portfolio every year. Besides unreasonable expectations, I think B&E didn’t have a strategy for picking dividend stocks in first place. Hence, he switched to indexing. Hopefully he doesn't abandon it for something else during the next bear market.

Dividend Dynasty – switched to indexing after a few years of dividend investing. One of the reasons for switching is that they couldn’t find good valuations. However, if you can’t find good valuations in stocks, then buying an index funds of stocks that is also overvalued doesn’t make much sense either. If you can’t find good values in individual stocks, then buying a basket of those individual stocks is not a solution.

I think index investing could be a great strategy for 80 – 90% of savers out there.  A busy family person, with a demanding career is better off focusing on that career. I would not want my doctor upset that their stock portfolio did bad in the first quarter, before they are about to operate on me. This is not because indexing is a magic strategy, but because a diversified portfolio businesses will benefit from growth in earnings, dividends and intrinsic values over long-periods of time. If history is any guide, a patient holder of a diversified portfolio of 50 dividend paying stocks will do very well over long periods of time as well. Indexing is a proxy for owning stocks, and holding them for decades. Dividend growth investing is a strategy where you pick stocks and hold on to them for decades.

There are different ways to build a nest egg - either through dividend growth investing or indexing. For example, my sibling has a busy life with 50 – 60 hours of work (both full time and a part-time), work around the house, and work looking after their kids and making sure they grow to be responsible adults. My sibling has invested in their 401K for years, and has been close to maxing it out, as their career progresses. They do not want to bother thinking about investments, track monthly net worth, etc. Of course , they also plan on accumulating a nest egg for 30 years, and are not sold on the FIRE that most here want. This is ok for them.

For my strategy, I want to earn a certain dollar income say after 2018. Dividends are a more stable, and more reliable way of living off a portfolio. Since I receive cold hard cash every 90 days or so, which also increases every year, I am more likely to stick to my strategy. It is easier to ignore stock price fluctuations, when stock prices are flat or low for extended periods of time, when your expenses are covered by dividends. I would not want to be in a position to sell shares when I need the money, and shares are flat or down for extended periods of time. I know I would hate it, and I would end up watching and stressing out over meaningless price fluctuations. However, for some retirees in 1966 – 1982, stock prices went nowhere for 16 years. Between 1929 – 1954, stock prices also went nowhere. If you only rely on capital gains to bail you out, you risk running out of money when stocks are not in favor and their prices do not go up every year. You risk running out of money if you expect to sell 4% of your portfolio each year, it has a low yield, and stock prices are flat for extended periods of time.

I am buying income that increases over time consistently. My total returns are unpredictable but my income is more reliable than capital gains, and that's what matters in my case.

Instead, I try to focus on the dividend income I receive. Dividends are more stable and predictable than capital gains, which make them ideal for my retirement plan. Dividends come from corporate profits. When Coca-Cola (KO) declares and pays a $1.32 dividend, every shareholder receives that cash. Warren Buffett's Berkshire Hathaway receives $132 million in cold hard cash every single quarter. If I were to sell shares of Berkshire Hathaway (BRK.B) or Coca-Cola (KO) to fund my retirement, it is very likely that I will sell at the worst possible time, if I needed the money. Annual Stock market returns are not predictable over short periods of time. As a future hopeful retiree, I need predictability of returns. Therefore, those who tell me they will sell off shares to fund their retirement are essentially telling me that they know the stock market will return at least 4%/year and never have a down year. The reality is that while in the next 25 years average stock market returns could be positive, it is also possible that returns will greatly vary over shorter periods of time. Creating a strategy based on expectations of stock price returns every year, seems very speculative.

I personally would have a hard time sticking to index funds only. I have followed the stock market for 16 - 17 years now. I have looked at historical returns from a variety of countries, regions, sectors spanning four centuries. When stock prices go down, it makes a lot of investors want to question their judgment. If you had to sell during a prolonged bear market like the one we had between 2000 – 2012, you will have suffered psychologically and financially. Selling more shares when prices are low, when your asset base has already shrunk, is something I would try to avoid with my retirement money.

I remember how in 2008, it was tough to watch the value of my 401K fluctuate by 7% per day on the bad days. I had no trouble checking my dividend portfolio however, where I frequently saw cold hard cash deposited in my account. This provided positive reinforcement to stick to my investment, and add more to stocks. Of course, I also added to the 401K, but I found watching only prices, and relying only on prices to achieve goals to be more speculative. I found dividend more comforting, and providing the positive feedback to stick to my strategy and not abandon ship.

Constantly checking prices could create the urge to do something. This is hazardous to long-term compounding of wealth. In addition, constantly checking performance versus a benchmark is counter-productive for a dividend investor like myself. It gives me no actionable insight to know that I have outperformed in one year but underperformed in another. Of course, using my strategy I have done better than S&P 500 since 2007 – 2008. My portfolio has also done better than portfolios that invest in US stocks, International Stocks and/or Fixed income since then.

I am not trying to say indexing is a bad strategy. The point I am trying to make is that investing without a strategy is dangerous. The investor who understands their goals and objectives, and thinks about how to get there, and how long it would take to get there, will have the strength to remain patient when things get tough. An index investor who keeps adding to their funds, and doesn’t panic when things get difficult, will succeed over time. The index investor who gets scared away, and abandons their strategy, will not succeed. The index investor who makes an investment regardless of valuation will also suffer as a result. The index investors who chased returns in 1998 – 2000 and overpaid, didn’t fare too well.

The same is true with dividend investors. Those investors who chase high yielding stocks without understanding whether distributions are sustainable, and without doing any due diligence, will not succeed. The investor who also purchases a dividend growth stock that has not been able to increase earnings for several years, is also making dangerous moves. If you are prone to using too much leverage, buying and selling too often, you are stacking the odds against you. If you are afraid to stick out for 1 – 2 years, you will not succeed in dividend investing. In addition, if you overpay for future growth, your returns will suffer as well. The dividend investor who purchased Coca-Cola or Wal-Mart in 1998 – 2000, didn’t do too well. The investor who pays over 30 times earnings for Brown-Forman (BF.B) or Starbucks (SBUX) today is reducing their odds of success.

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