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Wednesday, November 18, 2015

Relative Performance Comparisons are Useless for Dividend Investors

I started my site dedicated to dividend investing in January 2008. I had been able to accumulate some money for the first time in 2007, and had spent hundreds of hours teaching myself how to properly allocate it. The purpose for this site was to make myself do the work to form an opinion, and to share what I have learned and share my thoughts on investing.

Since the very beginning of the site, my goal has been to accumulate enough income producing assets. Once the income from those assets exceeds my expenses by a comfortable margin of safety, I would consider myself retired or financially independent ( you pick the correct word).

One of the lessons I have learned is that investing is part art, part science. A certain lesson can be very useful in some scenarios, but also very dangerous in others.

For example, if you have a winning investment strategy, you need to stick to it through thick and thin. An investor should not let temporary periods of bad performance influence you to jump ship. In my book, a strategy should only be evaluated based on whether it can help in reaching my goal of attaining financial independence.

On the other hand, you should also know when your strategy is no longer working or doesn’t make sense due to certain factors. If you stick to a strategy for too long, you will be unable to reach financial independence on time.

Is your head spinning yet?

I believe that dividend growth investing is a winning investment strategy. Hopefully, my story of going from zero to $15,000 in annual dividend income given annual expenses of $18,000 - $24,000/year is a testament to this idea. However, I know that in the world of real-time investing, there are a lot of distractions out there. One of those distractions is benchmarking. I know of a lot of investors, who compare their returns every month to a benchmark. The logical outcome is that in some months they do better, while in others they do worse. The issue is that for most investors out there, they invest with the goal of providing for their future selves from 20 - 30 - 40 years down the road. This is where I believe that comparing to others every single month or quarter is a useless exercise, as long as one is progressing towards their goals. This is because you never know what your future returns will be, let alone what future returns relative to other future returns will be. We have no control over what future investment returns will be, and could only make some wild guesses based on past returns. And all investors know that past performance is not reflective of what future performance will be.

A far more important thing you can control is the level of savings you can achieve. You also have control over expenses you pay and the amount of taxes you can defer. By that measure, I expect my dividend portfolios to have rock bottom costs, and to compound tax-free for decades in my retirement accounts.

As a dividend investor, I usually ignore those comparisons, and I focus on the growth in dividend income of course. This is because that overall, a diversified dividend portfolio will at least match the rate of return of a broad US index over time. During a time where stock prices go down or stay flat, a dividend portfolio will do much better than the typical index fund. When the stock market goes up, the typical dividend growth portfolio will likely match those returns. However, when the stock market goes up a lot in the last moments of a raging bull market that is driven by speculative excess, dividend growth stocks will likely do worse.

The best example of a raging bull market (third phase) was between 1998 and early 2000, when traditional companies were punished, since investors wanted to buy technology and internet companies that had no revenues or earnings. During that time, Warren Buffett was said to be out of touch with investing. Those are not my words, those are the words of internet guru Seth Godin from 1999.

Since late 2012, we have had a lot of risky growth companies which have propelled stock market indices higher. Many of those companies do not have earnings, but offer the possibility of future earnings growth as a justification for their lofty valuations. In the ultracompetitive world of technology, where the hottest technology can become obsolete in a second, I am unable to value those enterprises. So this is a blind spot, where I am unable to evaluate the moats of companies in a fast changing fields. If you are able to identify and select growth companies successfully, you might be able to earn tremendous profits. Unfortunately, most investors who chase growth stocks end up losing a lot of money in the process. If you overpay for future growth, you might not be able to earn any profits, even if the growth is realized. Just check the performance of Microsoft the stock since 2000 to the earnings per share on Microsoft the company if you do not believe me.

Over a period of 10 - 20 - 30 years, a portfolio of dividend stocks will do at least as well as say the S&P 500. However its results will likely vary in the short-term. If you look at the performance of the dividend aristocrats index between 1989 to 2014, you would see this point illustrated pretty well.

As you can see, there is variability in annual returns. These variations are useless, and could simply scare you away from your strategy at the worst time possible. The worst thing is that you will be compounding the mistake of selling low, by switching to a strategy that has done well recently. Yet, I see this error done by investors time and again.

A severe period of long-term underperformance will be the result of picking companies that failed to grow earnings and dividends. I would know that I am a bad stock picker long before that. This is because I would have seen the problems when I evaluate annual dividend income, organic dividend growth rates at the portfolio level and portfolio companies individual fundamental performance. Therefore, even in a situation where I fail against all odds of intelligent portfolio allocation, I would still get limited use of benchmarking against S&P 500.

Of course, you know that I have bought those dividend stocks for the stability of those dividend checks. All I care about is that I can generate $1,500 - $2,000 in monthly dividend income from my portfolio that grows above the rate of inflation. Let’s say that my portfolio generates enough income to pay for my expenses for the next 30 – 40 years. Let’s also say that in 30 years, my portfolio which has provided me with dividend income to live off each year is now valued at $10 million. Let’s also assume that had I invested in an S&P 500 index fund, my portfolio would be worth $5 million.

If I can be honest with you, I would not feel any different that I have done better than the S&P 500 over a period of 30 years. This is because my goal is to live off dividends. As long as the value of my dividend income maintains purchasing power so can I live off it in retirement, I do not care how my portfolio does relative to an index.

Let’s turn the tables around. Let’s assume that my portfolio is worth only $5 million in 30 – 40 years. Let’s assume that if I had invested in an index fund, the portfolio would have been worth $10 million. Again, I would not care as long as my dividend income kept growing above the rate of inflation. In a world where a portfolio value of $1,000,000 is more than what I will ever need, anything over that $1,000,000 mark would be just excess anyway. A portfolio valued at $1 million could easily generate annual dividend income of $30,000 - $35,000, which is tax-efficient and grows faster than inflation over time. A large portion of working adults in the US earn less in after-tax income than that. If you benchmark yourself to others however, you will be dissatisfied that there are others who are earning more than you. If you decide to keep up with the Joneses, you will never be happy with your accomplishments. This is because you can always find someone who is earning more money than you and whose investments will perform better than yours. This of course is a trap. I believe comparing myself to a benchmark such as S&P 500 is similar to the trap of keeping up with the Joneses and is similar to keeping myself stuck in the rat race of performance benchmarking.

We also know that we are in this game for the long-term. This is why I have said that comparing my results to S&P 500 does not really add any value. Most index investors will disagree with me of course. Many index investors erroneously claim that they have superior performance. The truth is that  the term "indexing" varies from individual to individual. Some indexers hold 100% of money in US stocks, others hold 60/40, others hold 1/3 US Stocks, 1/3 International Stocks and 1/3 Bonds. According to a wiki, the last is a recommended allocation.

Of course, indexers are not really telling you that they do not have 100% of their portfolios in S&P 500 either. Most index investors hold a large allocation to bonds, a large allocation to foreign stocks and a large allocation to US stocks. This asset allocation where a third is in bonds, another third is in US stocks and the last third is in international stocks, has done much worse than the S&P 500 over the past decade.

In my case, I opened a retirement account in May 2009. I bought some Abbott (ABT) with the proceeds, and just set to reinvest the dividends. I also put the rest in a Vanguard Target  Retirement 2045 fund (VTIVX). Since then, the target fund has done worse than the S&P 500. The investment in Abbott, along with any shares received from the 2013 spin-off of Abbvie (ABBV) have done much better than S&P 500. That doesn't really matter to me however.

The important thing for investors is to reach their goals, not care whether they are doing better or worse than some other group of investors.

My goals are to grow dividends above the rate of inflation. If however I am unable to find quality dividend growth stocks available at attractive valuations, I will have to reconsider my strategy. If I am unable to find companies then I will likely reevaluate my strategy. In addition, if more companies in the future decide to scrap dividend payments for stock buybacks, my strategy would likely have to be reevaluated. Over the past 8 years that I have been doing this, I have always found quality at a reasonable price however.

What are your goals as an investor? Do you compare yourself to a benchmark? How often do you do that?

Thanks for reading

Relevant Articles:

Comparing your results to S&P 500 could be dangerous for dividend investors
The Biggest Investing Sin Exposed
How well do you know your investment strategy?
Investors Should Look for Organic Dividend Growth
Are performance comparisons to S&P 500 necessary for Dividend Growth Investors?