Wednesday, April 13, 2016

Why relative performance comparisons provide no value to me

As a dividend growth investor, my goal is to generate a certain amount of money that would pay for my expenses in retirement. I work to achieve this goal by creating a portfolio of companies that include certain characteristics such as a track record of dividend growth exceeding a decade, good valuation, decent growth prospects, strong brands and strong competitive advantages etc. I evaluate my progress by comparing the amount of dividend income that covers my expenses. Right now, my dividend income is expected to cover 83% of expenses on the low end of annual expenses and 63% at the high end of my expenses. However, I do not track my total returns, which irritates many out there. But I couldn't care less.

I believe that tracking my total return is a waste of time. This is because based on the studies I have read, and the data I have seen, a diversified portfolio of stocks will likely get a similar total return to what the so called market would get. Plus, if I “underperform” some benchmark over a short period of time, I would feel the pressure “to do something”, which goes against the tenet of reducing portfolio turnover. And believe me, the pressure to switch to some other strategy will be highest after a stock has gone nowhere for a while, causing you and everyone else to doubt your abilities.

For example,the stock price of McDonald's (MCD) had gone nowhere since the beginning of 2012. Plenty of investors were starting to get worried as a result of this. Newspapers, magazines and blogs were predicting the demise of McDonald's, as millennials supposedly didn't like its greasy food. Little in the form of research was shown to provide any support that people didn't like McDonald's anymore. But the stories and speculation to fill in media space were present nevertheless. Fear sells. I believed that the company will persevere, and I stated so in my analysis of McDonald's from 2015.

As I mentioned above, an investor is more likely to doubt themselves after a few years of "underperformance". Which is precisely why as a small investor I ignore performance benchmarking. I know that over the next 20 - 30 years my returns will be close to that of any group of US stocks. Whether I beat a group of participants in 10 out of 15 years is irrelevant to my goals. To reiterate, my goals are to earn enough dividends to live off in retirement. It is important to have enough, and to not fall for a rat race at work or in investing.

For example, if I had sold McDonald’s (MCD) in 2015 to buy S&P 500 index fund, because the stock price had gone nowhere, I would have lost out on all the upward compounding since then. And knowing investors, I can tell you that the time they would have sold would have been in 2014- 2015 when everyone was predicting the end of McDonald’s (MCD). Let’s see how that worked out, shall we? (the example below excludes dividends for the S&P 500 fund and excludes dividends from McDonald's therefore somewhat discounting the better return of the fast-food giant)

As I have said hundreds of times on this site, I am mostly focused on building out a sustainable stream of dividend income for retirement. I am choosing to focus on dividends, because they are more sustainable than capital gains. The amount and timing of dividends is easier to predict and live off, than the amount and timing of capital gains. Therefore, it makes perfect sense to focus on dividend income, and ignore the crazy stock price fluctuations, knowing that at the end of the day I am working towards reaching my own goals.

In my case, I stuck with McDonald's because I kept receiving a nice and growing amount of dividend income from the company. The quarterly dividend went from 61 cents/share in 2011 to 89 cents/share in 2016. I was receiving a 3.50% yield, and a dividend payment that grew above the rate of inflation, while patiently waiting for a turnaround. And when you are paid cold hard cash every 90 days, you can afford to be patient, because the company is "showing you the money".

The amount and timing of future returns is unpredictable. You may have a long a trying period of time, where stocks go nowhere for a decade. When stocks go nowhere for a decade, investors patience is severely tested. Only a person with nerves of steel will have the patience and perseverance to stick to their strategy during lean times. Only after the last impatient buyer sells, can you get some price appreciation.

When everyone talks about making 10%/year in stocks, they are forgetting to inform you that these are average annual returns over long periods of time. This average includes long periods of booms as well as long periods of little to show for your investing records. To add insult to injury, your mind will be playing tricks on you, telling you with is perfect 20/20 hindsight that you would have been better off, had you bought something else.

Most ordinary human beings would bail at the first sign of trouble. Therefore, instead of holding on to something that does poorly relative to something else that may be doing better, they sell and move on. This is a mistake, because as we mentioned above, the nature of stock market returns is lumpy. If you sell when things look depressed in order to buy something merely because it has done better, you are in effect selling low and buying high.

Full Disclosure: Long MCD

Relevant Articles:

Are you patient enough to become a successful dividend investor?
McDonald's (MCD) Dividend Stock Analysis 2015
How many individual stocks do I need to consider myself diversified?
What are your dividend investing goals?
Living off dividends in retirement

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