Wednesday, November 8, 2017

What I learned from analyzing my investment record

I have been investing in dividend growth stocks over the past decade. I have shared with you my strategy, how I identify companies for research, how I analyze companies, how I select to buy them, and how I build a portfolio.

Regular readers know that I am truly passionate about investing. I have focused my attention to investing and business for almost 20 years, starting out as early as high school. One of the results of this is the fact that I try to gain more knowledge over time, in order to improve. The trait I picked from many of the books I have read is that successful investors tend to analyze their past investments, in order to uncover any recurring errors.

Inspired by this knowledge, I have tried to go back to my investment detail since 2008, and understand what errors have been made in order to avoid repeating them again. Making errors is natural if you are trying to achieve anything in life. What separates the winners from the losers is that the former study their successes, as well as failures, in order to improve. The superwinners are those who are smart enough to study other people’s mistakes, in order to avoid repeating them in their own situations. After all, life is too short as it is – therefore we do not have the time nor luxury to learn from mistakes that could have easily been avoided. This is the main reason I am sharing mistakes here – in order to help YOU avoid mistakes I have made.

Here is a short list:

1) Chasing yield is bad.

Many inexperienced investors believe that dividend investing is all about finding the highest yields possible. My worst mistakes have been in buying companies, mostly because they had a high current yield. While I had a process for investing, I convinced myself that those companies are something special, and that I should ignore any warning signs. The two companies where I chased yield were American Capital Strategies (ACAS) in 2008 and American Realty (ARCP) in 2013 - 2014. I was seduced by the high yields, and did not analyze the dividend safety in the skeptical manner that I should have. Long story short, both companies ended up eliminating dividends, and I sold at a loss. What saved me was the fact that none of them ever accounted for more than 1% of my portfolio. I have had other dividend cuts, but most of them were in entities that were able to pay dividends out of cash flow or earnings, and the business conditions turned sour or management decided to start off with a clean slate.

2) Selling is costly

Plenty of  investors tend to actively monitor their holdings on a regular basis. The problem with this exercise is that this monitoring can trigger your brain into doing things that you may later regret. One of those activities is selling a good company for a variety of BS reasons such as "noone goes broke taking a profit" or "the stock overvalued now, I will buy it later at a lower price" or "there is another stock that is cheaper"or "I can increase my yield by buying something else". I have made this mistake as well, selling perfectly good companies for no good reasons, only to replace them with companies that ended up sorely disappointing. In the majority of sales I had ever done, I realized that I would have been better off simply doing nothing. Worst of all, I also ended up paying taxes and commissions on selling, along with the steep opportunity cost of replacing a great company with a mediocre one.

If you want to look for examples, this post outlines a few. I am glad I have taken a more passive approach to my portfolio, where I almost never sell now ( unless I am forced to by a company being taken over)

Ironically, even selling after a dividend has not been a smart move for me either. I would have been ok simply holding off on the dividend cutters. My automatic rule has been to sell immediately after a dividend cut. I am seriously reconsidering this rule, and turning it into a guideline.

3) Keep costs low

In general, it is important to keep activity and turnover as low as possible. The case can be made that the investor should do a lot of regular buying over time, and very little, if any, selling. This ensures that costs are kept low, and the ability to make mistakes is reduced further.

When you keep costs low, this means there are more money working for you.

The appealing feature of dividend growth investing is the fact that once you purchase your equities, you are not charged a fee for holding on to your investments. These days, certain brokers such as Robinhood and Merrill Edge offer commission free trades to their clients. So it is even possible to have no investment costs whatsoever ( this is lower than most index funds even).

Most of my readers are also of the DIY type, who do no engage the services of an expensive investment adviser or an expensive mutual fund. If you pay 1% of assets under management to an investment adviser, you are essentially being charged a 33% annual tax on your dividend income, provided that your holdings yield 3%. It is no wonder that many financial advisers actively hate dividend investing - their services appear more expensive when framed as a tax on dividend income than as a fee on total assets under management. In addition, there are some said advisers who also sell mutual funds that cost 1% - 2%/year. This is highway robbery if you ask me.

When you avoid financial advisers, you get more money to keep for yourself. I am glad I always managed my own money, and never paid more than a commission here and there. When I did pay commissions, I always made sure that the total cost never exceeded 0.50% of the total transaction value.

4) Taxes matter ( to an extent)

Not maxing out retirement accounts was one of the mistakes I made in the first few years of my journey. When you generate investment income during your accumulation years, you have to pay taxes on it. Taxes are a real cost that reduced performance and dividend income available for you to spend or reinvest. We want to keep them as low as possible.

Even when you earn qualified dividend income, you still have to pay 15% - 20% to the friendly tax authorities ( in addition to state income taxes if you are in the highest tax brackets, plus a potential 3.80% medicare surcharge tax on top of that). Unfortunately, this presents a drag on the compounding process. Your goal as an investor is to have the maximum amount of money working for you, and not to lose any dollars to the tax man. Each dollar that doesn't compound for you, is a dollar lost forever.

Since my wake-up call in 2012-2013, I am maxing out everything available under the sun for me. This includes maxing out my 401 (k) ( both pre-tax and after-tax), SEP IRA, Health Savings Account (HSA) and Roth IRA. I am essentially to the point where my whole after-tax salary is placed in retirement accounts, while I spend my taxable dividends and side income for ordinary expenses.

The other thing to consider is to be as inactive as possible in your portfolio investment decisions. The more you trade, the higher the costs associated with this turnover. When you sell stock, chances are you may have to pay a tax on any gains generated in the process. This further reduces the amount of money left to compound for you. At this time, long-term capital gains are taxed similarly to qualified dividends. However, short-term capital gains are taxed at your ordinary income tax rates.

Of course, while taxes do matter, you should never let the tax tail wag the investing dog. Do not make investment decisions merely for the tax purposes. Always focus on the investment side first, and taxes second.

5) Diversification matters

I believe that diversification is the only free lunch available in investing. I subscribe to the idea of spreading my wealth in as many companies as possible. It is also important to think about spreading my wealth in other asset classes, provided that they offer attractive returns. Diversification is important, because the future is largely unknown. Spreading your investments means that you have a higher chance of being able to keep your wealth even if some of your assumptions are incorrect. It is important to own as many companies as possible, without sacrificing quality, in order to reduce the risk to wealth and income if one company doesn't perform as expected.  You do not want to be dependent on the success or failure of just a handful of investments. As your net worth increases past a certain point, it makes sense to focus more on wealth preservation.

After reviewing my investment record, I have recognized the fact that I never know which will be my best investments in advance. I can tell you on aggregate what I am looking for, but I never know which specific investment will perform as well as expected. This is why it makes sense to own as many companies as possible that meet my basic criteria, and to also buy them over time, as long as they offer good value for my money. This is why it also makes sense to equally weight positions in a diversified dividend portfolio. I want to give each company an equal chance of success.

While I make mistakes, their effect has not been threatening, because they had low portfolio weights. When you own an equal weighted portfolio of 100 individual companies, the worst that one company can harm you is a total loss of 1% of total net worth. Actually, the downside is much less than that,  because dividends reduce the amount at stake, and because I reinvest them selectively elsewhere. However, the upside in each position is virtually unlimited.

6) You make money by staying the course

This is the most important lesson for all of us. Staying the course through thick or thin has been the way to wealth in the US over the past two centuries.

It takes work to identify great companies, analyze them, and purchase them opportunistically at attractive prices. However, those items are just part of the success equation. It is very important to keep investing regularly, through thick or thin. It is even more important to patiently stay the course, and let the power of compounding do the heavy lifting for you.

The investor's chief enemy is likely to be themselves. I have seen too many investors trying to time the market and selling out, waiting for a correction or selling out in fear of losing money. Those are mistakes. The real money in investing is made by buying and patiently holding over many years. This is the lesson learned from studying the most successful dividend investors in the world.

While I have had a couple of companies cut dividends, I have also had an equivalent number of companies that have been multibaggers that have also generated double-digit yields on cost in a decade.

I never knew which of the companies I own will do the best. However, I do know that if I assemble a diversified portfolio of solid dividend blue chips over time, and purchase them without overpaying, I will come out ahead in the long run. As we all know, the slow and steady accumulation of income producing assets on a regular basis, and the patient compounding of dividends and capital over time will win the race and help us reach out goals.

As of the time of this writing, my forward dividend income has exceeded my dividend crossover point after a decade of saving and investing.

Relevant Articles:

Should taxes guide your investment decisions?
An Investment Plan Helps You Stay The Course
My dividend crossover point
Taxable versus Tax-Deferred Accounts for Dividend Investing
How to become a successful dividend investor

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