Wednesday, July 1, 2015

The most important rule about dividend investing

As a dividend investor, my main goal is to attain financial independence when dividend income exceeds expenses by an adequate margin of safety. I am going to achieve that by creating a diversified portfolio of attractive dividend paying businesses that are purchased at attractive valuations, reinvest dividends and new capital, and then one day live off these dividends.

Unfortunately, it takes time to accumulate a sufficient stream of dividends, that would allow you to be financially independent. In my case, it would be about 10 years of meticulous saving and investing, through thick and thin when I achieve my target dividend income around the end of 2018. However, the preceding five to ten years were equally important, because I was able to avoid debt whatsoever, which many of my peers were burdening themselves with. It takes and will take a lot of dedication and persistence to eventually reach my dividend crossover point.

Because the fruits of dividend investing take time to grow to a meaningful amount, it can be difficult to stay motivated throughout your dividend investing journey. The human mind can play tricks on you, and you think about shortcuts on how to get there faster. This is a dangerous behavior, which can detract you from your goals. In other words, dividend investing is a great strategy for those who stick to it. But for those who don’t, it is quite possible that you won’t be able to reach your goals. Therefore, I believe that if you avoid big losses, your odds of success increase exponentially.

To paraphrase Warren Buffett, rule number one is to never lose money, while rule number two is to never forget about rule number one. What Buffett means through this quote is that investors should avoid behaviors that can lead them to losses, and only focus on activities that make money, such as following your dividend investment strategy through thick and thin. I believe that your dividend winners would take care of themselves, but your dividends losers seldom would. If you fall behind on your goals due to low level of savings, you should avoid chasing yield, buying on margin or speculating with options. Instead, pushing the goal timeframe to a more reasonable date is a better approach.

I have been overdoing on everything about Buffett over the past few years, and can tell you that one of the reasons why he became so successful is not because of smart investments he has made, but because he avoided huge losses along the way. Even with dividend growth investing, you will have some losses in your 20 – 30 year investment career. However, if you avoid certain things such as those listed below, and stay your course, your chances of achieving your dividend goals increase exponentially.

One factor that could derail your plans is impatience. It takes time and perseverance to save money, find good stocks to invest, and put cash to work for you. The time it takes you to reach the dividend crossover point depends on dividend yield and growth rates, plus the amount you put to work every month. The impatience could make you do thinks such as searching for shortcuts like chasing high yielding stocks, tinkering too much with portfolios, using leverage or speculating in riskier stocks.

I am not a big fan of too much tinkering with my portfolio. I believe that I should hold on to my winners for as long as possible. If a company keeps raising dividends, and has not cut them, I just hold on to the stock. Selling is something that almost always sets me back, because I have been known to sell an otherwise great dividend stock, merely because it went ahead of itself in valuation. I would then proceed to sell and pay taxes on capital gains, and put my capital in another enterprise that might not do as well as the original security. As a result, more often than not, I am worse off after tinkering with my portfolio. I would have been better off by simply holding on to the original company, and receiving the dividends in cash. This doesn’t mean to never sell, but to prevent yourself from tinkering too much with portfolios, by selling something that is 20% overvalued from fair value in order to buy something that is 10% undervalued from fair value.

I am also not a fan of excessive leverage, although I have used it as a smoothing mechanism over time. If you purchase shares with your money, the worst thing that can happen to you is lose all the money. However, if you purchase shares with borrowed money, the worst case scenario is that you lose all your money, and you then owe money. Leverage could be a powerful force either way however, and one should learn about it in order to make the intelligent choice whether it is for them or not. For the majority of investors, leverage might not be an intelligent option.

Another thing that can prevent you from achieving your goals is purchasing securities that you do not understand. I would be the first one to admit that I have done this before. In fact, I once owned shares of American Capital Strategies (ACAS), which was a business development corporation that paid a mouth-watering double digit yield. I bought it for the 10% dividend, without really understanding how sustainable it is. Lucky for me, the dividend was eliminated soon after I purchased the stock, and I learned a valuable lesson along the way to never buy a stock without understanding risks and rewards. I also learned to never chase yields blindly.

I have also learned not to be envious of others, and stick to my strategy. For example, if you see that your friend from college just quadrupled their money on Tesla (TSLA), that doesn’t mean you should go ahead and start speculating in risky technology companies selling for high valuations. Instead, you should focus on why you got into dividend investing in the first place, and determine whether you are on track to achieve your goals. For me personally, I receive a kick each morning that dividends are deposited in one of my brokerage accounts.

I agree 100% with the quote from John D. Rockefeller, who said:

Do you know the only thing that gives me pleasure and joy? It's to see my dividends coming in.

In order to avoid those traits, you need a dividend investment plan, that would spell out things like:

1) How to select companies
2) At what prices to purchase them
3) How to protect your capital
4) When to sell

Once you have the plan, and the persistence to stick to it, you should be able to stay the course and greatly improve chances of success. I have written a few lengthy articles whose goal was to essentially reinforce readers to stick to their dividend strategy. Based on previous articles on behavior dividend investing I have written, I can say that I was very pleasantly surprised that many of my readers know to stay the course, stick to their plan and maintaining a laser sharp focus on achieving their goals. This article is merely a reminder to keep sticking to your plan. If you notice any of the “bad” behaviors listed above, this article should serve as a reminder to stop them.

To summarize, the only rule about successful dividend investing is avoiding folly and losing money. If you take care of your downside dividend risk, your winners will take care of themselves and shower you with dividend raises for decades to come. Having a dividend investment plan will help you reach your goals, and help you stick to your strategy through thick and thin, in order to achieve full potential.

Full Disclosure: None

Relevant Articles:

Successful Dividend Investing Requires Patience
How to become a successful dividend investor
How to retire in 10 years with dividend stocks
My dividend crossover point

Popular Posts