Thursday, February 20, 2020

The Do Nothing Dividend Portfolio

One of the lessons I have learned the hard way over the years I have invested in dividend growth stocks is that it rarely makes sense to sell a security.

I learned this lesson by observing my investing history over the past decade. As you know, I try to buy companies that fit my parameters for a dividend track record, valuation, and fundamental performance. I then monitor how my portfolio companies perform over time.

This is where I got into trouble in the first place. I would sell a company, because its earnings would temporarily hit a ceiling. The stock price would go down, and you would have all those articles telling you that the business is not doing well. Articles are usually well articulated to the point where I am sitting there, questioning my judgement. Then, as I sell the security, I feel a sense of relief. This is a stupid feeling however, because essentially I sold low because I wasn’t patient enough in the security I was hoping to own through thick or thin. I then would reinvest the sales proceeds into another company, which seemed cheaper. However, I ended up being worse off, because it usually turned out that the original company had some short-term issues, and rebounds strongly after a management shake-up. The second company does ok, but not as well as the one I sold. Even if it did just as well as the original investment, I am worse off, because I pay transaction costs and taxes on any gains. This is a whole lot of investment activity for no marginal benefit. It is speculation at best, and a gambling behavior at worst.

I have learned that I should let company managements do the work for me. I have learned that monitoring an investment should not result in micromanagement, and active trading ( gambling).
That’s because I do not know in advance if a company I own is experiencing some temporary problems or this is the beginning of the end. The problem is that no one does. However, when a company has a lot of problems, its valuation shrinks as impatient sellers sell at any price, thus depressing the value. This creates the opportunity to acquire a stock, rather than sell it. Alternatively, when a company does well, its valuation is quite high.

Either way, no one can predict the future. Which is why it is best to build a diversified portfolio of blue chip dividend growth stocks, and let it do the heavy lifting over time. Jumping in and out of positions is a bad idea, that will leave you worth less. This idea of buying and never selling applies to companies that have a track record of annual dividend increases, and also applies to a diversified portfolio of such companies. I used to consider a portfolio diversified if it had at least 30 individual securities, but as I grow older, I want more diversification. Since I do not think that monitoring is good enough to forecast whether we have permanent troubles that require a sell or a temporary issue that requires the investor do anything, I can hold 100 or 200 individual securities quite easily. If I had a say on weighting, I would go for equal weighting of each company.

When you find good companies to own, own them for the long term. Do not interrupt compounding unnecessarily.

Armed with the knowledge that selling stock is bad, I then wanted to test this hypothesis with other investors. Luckily, a lot of investors I follow tend to post their portfolios and investment decisions in pretty much real time. I diligently tracked their behavior, and found out that they too were selling too quickly. The companies they sold ended up doing pretty well, while the companies they bought with the proceeds turned out to do less well. These investors would have been better off doing nothing, than buying and selling too much.

I sometimes receive criticism that I reached this conclusion, because we have been in the longest bull market in history ( 10 years and counting). Unfortunately, there are multiple issues with this assertion. The first is that dividend investing always looks easy in retrospect – I received this criticism in 2014 as well and even devoted a whole article to it.

I made a calculation where I compared two investors in the accumulation phase. The first investor invests $1,000/year at the beginning of each year between 1980 and 2019 in a diversified group of US stocks ( using VFINX historical data that accounts for dividend reinvestment once again). The first investor ends up with $544,037.82.

The second investor also puts $1,000/year, but manages to invest his annual contributions in the lowest point of the year. They end up with only $586,776.51, despite having perfect timing for 40 years in a row.

As you can see, consistent investing beats timing the markets in the long run for most investors.  While noone can pick the bottom in stocks consistently for 40 years in a row, everyone can learn to invest regularly, whenever they have money to invest.

When you sell stocks you think are high, you are essentially timing the market. Also, when you think that bull markets or bear markets would end after a certain number of years, you are also trying to time the markets. As we have demonstrated before, timing the markets does not work consistently. Therefore, it is not worth even trying.

Another issue is that this assertion forgets about the idea that stocks usually go higher in the long-term. Some companies will fail, while others will deliver great results. We do not know which the best companies will be in advance, which is why we diversify and hold tightly for the longest amount of time possible. Ironically, this assertion is refuted by looking at data that spans several decades of academic research and casual observations alike. But let’s go back to the idea that companies you sell do better than the ones you buy with the proceeds, hence it is a bad idea to sell in the first place.

This is an error that is not only done by amateur dividend growth investors. This is an error that is done by Superinvestors such as Warren Buffett. In fact, he has stated on numerous occasions that Berkshire Hathaway would have been better off if he had simply gone to the movies, rather than sell perfectly great companies for no apparent reason.

Even the venerable committees in charges of S&P 500 or Dow Jones Industrials Average indices are not immune from errors. Research from Jeremy Siegel has uncovered that the portfolio of the original 500 companies members of the S&P 500 index from 1957 would have done better than the index itself. The decisions of the index committee actually cost investors anywhere from half a percent an year to a full percent an year over a period of a half of a century! In the case of Dow Jones 30, the index kicked out IBM in 1939, before the stock managed to go up 220 times in 40 years.

I have also discussed with you previously the success of the Corporate Leaders Trust, which is a mutual fund that was launched in 1935. The mutual fund held a number of blue chip companies that paid a dividend. It took a very passive approach to long-term investing, as it seldom sold stocks.

Of course, this discussion would not be complete without mentioning my favorite article on the Coffee Can Portfolio. In the article, a portfolio manager finds out that an investor who followed their buy recommendations but never following the sell recommendations end up doing much better than someone who sold frequently.

The most fascinating aspect of this exercise is that when I reach out to investors who make this error, and pointing it out to them, they end up doubling down on the behavior and not learning from the mistake.

I believe that investors sell securities for a variety of “reasons”. I put the word in quotation marks, because those reasons are seldom good enough to warrant selling a stock. Usually, these reasons stem from impatience. The investor sees a stock going down in price, or the stock price goes nowhere for a few years, or earnings per share hit a plateau or perhaps there are some bad news around a company. These “reasons” just trick the investor into action, when on the aggregate they may be better off just doing nothing. Instead, investors should carefully track their investing decisions, and make sure their “reasons” are not simply justifications to excuse costly investing behavior. Perhaps they have the innate gambling instinct for action, regardless of how expensive investment activity will be ( in terms of opportunity costs missed, taxes and expenses).

Holding stocks for the long-term is not as risky as most believe. That’s because a stock can shower shareholders with dividends for year. Companies also distribute excess profits in the form of special dividends or share buybacks. Companies get acquired for stock or cash, or merge to create new companies. This is why the shareholders of milk bottle manufacturer Thatcher Glass generated exceptional returns, despite the fact that milk is now sold in paper or plastic containers. Companies also spin-off subsidiaries, which is perhaps why an investor in Eastman Kodak would have generated a respectable return of 7% - 8%/year over the past 60 years, despite the fact that Kodak went bankrupt in 2011.

In conclusion, I believe that once an investor builds a diversified portfolio of blue chip dividend compounders, they should hold through thick or thin and not sell. On aggregate, selling would lead to a worse outcome than merely holding due to opportunity cost, taxes and commissions/fees/slippage. The future is difficult to forecast, which is why it makes sense to devise a portfolio plan that attempts to give you the best odds of success, while minimizing the impact of failures along the way. Never selling a diversified portfolio is a strategy that provides the best odds of success for the long-term investor with a multi-decade holding period.

Relevant Articles:

The Perfect Dividend Portfolio
The Coffee Can Portfolio
How to Make Money in Your Sleep with Forever Dividend Investing
How to improve your investing over time
Investing Lessons Learned From Ten Years of Writing

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