Risk Tolerance and Smart Investing: When Fear shouldn't be a Factor

This is a guest post by Carson Brackney, writer for Personal Finance Analyst. Personal Finance Analyst is an online community of bloggers dedicated to taking the mystery out of money and helping you to live a happier, more successful life with the money you have.

New Jersey's Cooperative Extension Services (operated out of Rutgers University) offer a great online quiz that will calculate your level of investment risk tolerance. If you don't like that one, you can take a look at Yahoo's free calculator. Still not happy? Merrill Lynch has their own. And there are others. Many others.

And all of the calculators attempt to do the same thing--they want to tell you how much risk you're comfortable taking in your financial planning. Obviously, that's a tough nut to crack. We don't really have a standard unit of measurement for risk, after all. So, what you end up with is a numerical score that corresponds with a few sentences describing the way the calculator believes you feel about risk and money.

Is that valuable information? For some people, it might be. There are undoubtedly a few folks out there who aren't big fans of introspection who've never considered whether they're devil-may-care or risk aversive. Those horoscope-like explanations of what the results mean might give people a slightly better sense of what their feeling really mean in some senses.

In those ways, you could consider the risk assessment tools valuable. They also have some potential value if you find that your attitudes about risk are in direct conflict with your optimal personal finance objectives (more on that later).

Even though there is some value in calculating your risk tolerance, you shouldn't fool yourself into believing this information is truly mighty. Don't make the common mistake of assuming that your comfort level should dictate your resource management.

That's right, the argument that you should only invest at a risk level compatible with your own comfort level is wrong, wrong, wrong. If you're tolerance for risk is out of whack (in either direction), you don't necessarily need to change your investment pattern. You need to adjust your attitude instead.

That argument assumes an optimized investment plan, of course. The argument is quite simple. You should be following the best possible system to reach your financial objectives. If you are using that system and your personal sense of risk tolerance runs contrary to it, you need to change your attitude, not your plan.

Not everyone agrees with that. Statements like, "Your risk tolerance should determine a suitable asset allocation that is right for you" are common. There's a belief out there that you shouldn't invest if the move makes you uncomfortable.

That's a backwards perspective, though. You should be focused on developing a plan of action that will meet your needs and objectives. If you can do that while staying in your psychological "comfort zone", that's great. If, however, it moves you into uncomfortable territory, you need to change the dimensions of that "comfort zone".

Otherwise, you're setting yourself up for a long-term failure. If you need to undertake a certain level of risk to reach your goals, anything short of that is going result in you falling short of those goals. If the plan is sound and the strategy is workable, you should be at least somewhat comfortable in knowing you're doing the right thing. If you don't feel that way, it's time to either (a) persuade yourself to start or (b) prepare to be nervous for a while.

InvestorGuide.com lays out the argument:

We need to remember that it is not only our personal risk tolerance that we want to consider, but we also want to ask ourselves, "What is the appropriate risk to take?"

Asking how you feel about something is wonderful. Letting the answer dictate your personal finance strategy, however, isn't. Instead, you should be making decisions based on your own financial interests.

If you don't have a good plan and you're living on a personal finance roller coaster, it's fine to take stock of your comfort level and to act accordingly. If you're following the kind of smart plan you need to get ahead, however, your comfort level needs to take a backseat.

Relevant Articles:

- Diversifying into small and mid cap dividend stocks
- Dividend Investing vs Trading
- My Dividend Growth Plan - Diversification
- Don’t chase High Yielding Stocks Blindly

Colgate Palmolive (CL) Dividend Stock Analysis

Colgate-Palmolive Company, together with its subsidiaries, manufactures and markets consumer products worldwide. It operates in two segments, Oral, Personal, and Home Care; and Pet Nutrition. The company is a Dividend Achiever and a Champion. Colgate-Palmolive has paid uninterrupted dividends on its common stock since 1895 and increased payments to common shareholders every year for 46 years.

From the end of 1998 up until December 2008 this dividend growth stock has delivered an annual average total return of 5.90% to its shareholders. While the stock has largely remained flat for the majority of the past decade (except for the breakout in the stock price in 2007) most of the returns came from reinvested dividends.

At the same time company has managed to deliver an impressive 10.70% average annual increase in its EPS since 1999.

The ROE has consistently remained high, ranging between 57% and 475% over the past decade.

Annual dividends have increased by an average of 11.40% annually since 1999, which is slightly higher than the growth in EPS.
An 11 % growth in dividends translates into the dividend payment doubling almost every six and a half years. If we look at historical data, going as far back as 1977, Colgate Palmolive has actually managed to double its dividend payment every eight years on average. Just a few weeks ago Colgate Palmolive boosted its dividend by 10% for the 46th year in a row. The dividend is very well covered at the moment.

The dividend payout has ranged between a high of 51% in 2006 and a low of 33% in 2002. One positive fact is that the payout ratio has consistently remained below 50%. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings.

Despite the low dividend payout ratio and low P/E ratio, I require a dividend yield of at least 3% in order to initiate a position in Colgate Palmolive. Currently the yield is at 2.80%, and price earnings ratio is 17.

In comparison Procter & Gamble (PG) trades at a P/E multiple of 12 and yields 3.40%, Kimberly-Clark (KMB) trades at a P/E multiple of 13 and yields 4.70%, while Clorox (CLX) trades at a P/E multiple 14 while yielding 3.60%.
I would consider initiating a position in Colgate Palmolive on dips below $58.66.

Full Disclosure: Long PG, KMB and CLX

Get an updated Trend analysis for CL, KMB, PG and CLX.

Related Articles:

- Kimberly-Clark (KMB) Dividend Analysis

- Procter & Gamble (PG) Dividend Stock Analysis

- Clorox (CLX) Dividend Analysis

- Abbott Labs (ABT) Dividend Stock Analysis

Replacing dividend stocks sold

Dividend investors should not rely too much on the dividend income from a single stock or a single sector. In an ideal situation, in a portfolio consisting of 40 stocks, each security would have an equal weighting. In other words one shouldn’t have more than 2.5% in a single security at the end of his or her target period.

In real life however things are usually far from ideal. What could happen is that some dividend stocks would outperform the others and thus their weightings could be disproportionately large. In order to maintain the equal weights, investors have several choices besides selling the best performers and placing the proceeds in the underdogs.
One of them includes reinvesting the dividends from the stocks with the highest weights into the stocks with the lowest weights.

Another option includes adding extra funds to the stocks which have a below average weighting in your portfolio, as part of your process of regular contributions toward your portfolio.
An important thing to add is that one should not consider adding to a position, which no longer fits two or more points from your entry criteria. My entry criteria consists of several bullet points including:

1) A stock which has increased annual dividends for at least the past ten consecutive years (preferably for at least 25 years)
2) A price/earnings ratio of under 20
3) A dividend payout ratio of less than 50%. In certain cases such as Master Limited Partnerships, Utilities or Real Estate Investment Trusts, which distribute the majority of their earnings to stockholders, compare the current payout ratio to the historical one.
4) A dividend yield, which at least matches the dividend yield on the S&P 500. This criterion used to be a 2% initial yield for the majority of 2008, until yields on the S&P 500 rose to the highest levels since the early 1990’s. Currently I prefer to invest in stocks with a current dividend yield of at least 3%.

For example, if you have a position in M&T Bank (MTB), you would be receiving a quarterly dividend of $0.70/share. M&T Bank last raised its dividends in July 2007. Unless the bank raises its dividends by the end of 2009, it would lose its dividend aristocrat status.
Because of the unchanged dividend, I stopped re-investing dividends in the stock by the end of 2008. I also stopped adding to this position as well. The dividend payout is slightly above 50%, while the P/E and the yield are pretty attractive at 12.7 times earnings and 6%. Another thing that concerns me about M&T Bank is that it took $600 million in TARP money back in December 2008. My experience with other banks, which received TARP money, such as Bank of America (BAC), US Bancorp (USB), Wells Fargo (WFC) and BB&T (BBT), is that TARP receivers are very likely to cut their dividends.

Since I have started reinvesting my MTB dividends into other companies I own, my allocation in the stock has dropped to about 1.7% of my total portfolio value. This position contributes about 2.20% of my total annual dividend income. My yield on cost is 4%. If the dividend were cut while the stock was trading at $46 however, I would sell the stock.

The question now is what should I do with the money I received from the sale. My dividend income would be lowered, and I would now have $46 to invest, which is lower than my average cost of $69/share. In order to maintain my dividend income of $2.80/share, I would have to purchase $46 worth of shares in a dividend stock, which currently yields at least 6%. In the current market it is possible to find a solid dividend stock, which yields at least 6%. One example that comes to mind is Consolidated Edison (ED). Another is Kinder Morgan Partners (KMP). It is important to try and keep sector weights as well however.

On the other hand I could simply accept that my dividend income for this portion of my portfolio would be lower and simply invest in a promising candidate such as Johnson & Johnson (JNJ) or Abbott (ABT). It is more important to have a diversified stream of dividend income, rather than chase the highest yielding stocks when replacing dividend stocks sold in an effort to maintain your previous levels of dividend income. Check my example with General Electric (GE) for more clarification.

Back in February 2009, General Electric (GE), which was one of my favorites until the end of 2008 announced its intention to cut its quarterly dividends to the lowest levels since 1997. I immediately sold my position at a loss for $8.63/share. My cost basis was $28.97/share. My dividend income was $1.24/share, while my yield on cost was 4.30 %. The new dividend would have been $0.40/share, which makes up for a yield on cost of only 1.40%, much worse than rates on Certificates of Deposit. Even though I had stopped contributing to my GE position by the beginning of the fourth quarter 2008,GE made up about 1.00% of my portfolio value. This position also contributed about 3% of my total annual dividend income. Thus, in order for me to generate $1.24 in dividend income for every GE share that I sold, I would need to purchase a stock yielding 14.40%. In the current market, most stocks that pay such a high current dividend are very likely to cut their distributions. Thus, maintaining the dividend income just for this portion of my dividend portfolio was not worth the risk of chasing the highest yielding stocks. Instead I purchased shares in Abbott Labs (ABT), which generate almost the same income that I would have received had I not sold my GE shares. While in retrospect my sale of GE stock seems foolish as the shares have risen almost 50% since then, I do not see the same potential for dividend growth that I see for Abbott (ABT). With Abbott (ABT) I see the potential for stable dividend growth, fueled by its strong new product pipeline and the potential for initiatives in the medical device and pharmaceuticals fields. In retrospect I could have added to my position in Kinder Morgan instead, but this could have lead to me being overweight the largest master limited partnership in the US, which is something I try to avoid.

My overall dividend income is up almost 3% year to date, after several reliable companies such as Johnson & Johnson (JNJ), Procter and Gamble (PG) and Coca Cola (KO) continued their long history of sharing prosperity with shareholders through regular annual dividend increases.

Dividend investors who are trying to replace the lost dividend income from stocks, which cut or eliminated their dividends, should realize that it is important to diversify the number of holdings that generate income for them. While a dividend cut or elimination from a stock that generated 3% of your portfolio income hurts, one should keep an eye on the big picture and not repeat their mistakes. It is the diversified income stream that counts and not replacing dividend stocks sold with the highest yielding stocks matter, which would certainly increase risk. At the end of the day, the dividend cutter has already compromised your dividend income. Taking on a higher risk only leads to a vicious circle of not focusing on dividend growth potential, but on chasing the highest yielders, which is a game of wealth destruction.

Relevant Articles:

- Abbott Labs (ABT) Dividend Stock Analysis
- Dividend Cuts - the worst nightmare for dividend investors
- When to sell my dividend stocks?
- More Dividend Stocks to Avoid

General Motors (GM) bankruptcy trade

With General Motors expected to file for bankruptcy soon, GM stock price has been in a freefall. In fact shares have hit the lowest levels since 1932, which was the year Dow Jones Industrials Average bottomed amidst the Great Depression. The stock price is also below $1, making shorting the stock almost impossible. Bankruptcy was one of the options for the major US automakers, when I analyzed the sector back in November.
According to this Bloomberg article, once the company files for bankruptcy , the US government would get $30 billion from the US federal government as well as 9.5 billion from the Canadian government. In return the US government would own 60% of the “new” General Motors once it emerges from bankruptcy, while the Canadian government would own 12%. The United Auto Workers health trust fund for retirees will end up owning 17.5 percent of the new company with warrants to purchase an additional 2.5 percent in exchange for forgiving GM the $20 billion it is owed by the Detroit automaker. Bondholders and other creditors would get a 10 percent stake in the new GM, with warrants for an additional 15 percent, in exchange for $27.1 billion unsecured debt according to Bloomberg. If successful, GM will emerge as a leaner company with a smaller work force, fewer plants and a trimmed dealership network.
Shareholders would most likely get wiped out, with their shares being worthless once GM emerges from bankruptcy.
So how can you play the GM bankruptcy and potentially make money in the process? First, If you hold GM stock, I wouldn’t hope for the company rising to $10 anytime soon, so I would consider selling. Otherwise the answer is pretty simple: play it with options.
If you buy puts on GM, and the stock does become worthless you would end up making a nice gain in the process. Options are contracts which give the right but not the obligation to buy ( call) or sell (puts) a security on a given date ( expiration date) at a given price (strike price). In GM’s scenario, a bearish investor would consider purchasing puts on the stock.
I would consider GM puts with a strike price of $1 for this trade. The June 2009 $1 puts closed at $0.60;July 2009 $1 puts closed at 0.67 , while September and December $1 puts closed at $.71 and $.75 respectively.
The far out puts such as the September and December 2009 ones are much more likely to yield any significant profits, since this leaves investors ample time for the company to go bankrupt.
This is a highly speculative trade that shouldn’t be entered with more than 0.5% of your total portfolio.

Full Disclosure: None ( But I am looking to open a position in Sep or Dec 2009 $1 puts).

Relevant Articles:

- The future for US Auto Stocks
- GM Bankruptcy Filing Will Bring Taxpayer Ownership, Less Debt
- General Motors (GM) bankruptcy trade

Dividend Investors Running With the bulls

The stock market index S&P 500 has risen by 37.8% from its lows in early march. The S&P 500 is also almost 1.80% higher since the beginning of 2009. Investors are now being bombarded with conflicting advice from both from the bullish and the bearish camp. The bears claim that the rally overextended and due for a sharp correction once S&P 500 falls below 878. The bulls believe that bears are in for a surprise once S&P 500 breaks out through the resistance above 930 and the next leg of the new bull market begins.

Dividend Investors on the other hand represent a camp of their own. They keep receiving their dividend checks, holding on to the dividend growers and disposing of their dividend cutters and eliminators. Dividend Investors are quietly re-investing their distributions into more shares and are watching their income grow in the process. It doesn’t matter to them if the S&P 500 is at 1500 or at 700 as long as the dividends are being paid, and most importantly dividends are not being cut, which shouldn’t be a problem for most diversified dividend growth portfolios.

Several companies rewarded their patient investors with dividend raises.

SUPERVALU INC. (SVU), which operates combination stores, food stores, and limited assortment food stores, increased its quarterly dividend by 1.45% to 17.5 cents per share. In addition to that the company announced a program authorizing it to purchase up to $70 million of the company's common stock. SUPERVALU INC. is a dividend aristocrat, which has increased its quarterly dividend in each of the past thirty-six years. The stock currently yields 4.30%.

Lowe's Companies, Inc. (LOW), which operates as a home improvement retailer in the United States and Canada, approved a 5.9% boost in its quarterly dividends to 9 cents/share. Lowe's Companies, Inc. is a dividend aristocrat, which has increased its quarterly dividend in each of the past forty-seven years. The stock currently yields 1.80%.

The H. J. Heinz Company (HNZ), which engages in the manufacture and marketing of food products for consumers, and foodservice and institutional customers, raised its quarterly dividend from 41.5 to 42 cents per share. The H. J. Heinz Company had been a member of the S&P dividend aristocrats index between 1990 and 2002, before it cut its distributions in 2003. The company has resumed increasing its dividends to shareholders since 2004.
The stock currently yields 4.60%.

PPD, Inc. (PPDI), a contract research organization, that provides drug discovery and development services, post-approval expertise, and compound partnering programs, increased its annual dividend payments by 20% to 60 cents per share. PPD, Inc. has consistently increased its quarterly dividends since 2006. The stock currently yields 3.00%.

Monro Muffler Brake, Inc. (MNRO), which provides automotive undercar repair and tire services, increased its quarterly dividend by 16.70% to 7 cents per share. Monro Muffler Brake, Inc. started raising dividends regularly since it initiated its dividend policy in 2005. The stock currently yields 0.90%.

Fred's, Inc. (FRED), which sells general merchandise through retail discount stores and pharmacies, increased its quarterly dividend by 50% to 3 cents per share. Fred's, Inc. doesn’t have a history of regular dividend increases. The stock currently yields 0.90%.

Flowers Foods' (FLO), which engages in the production and marketing of bakery products in the United States, raised its quarterly dividend by 17% to 17.50 cents per share. Flowers Foods has increased its quarterly dividend in each of the past 7 years. The stock currently yields 2.90%.

Full Disclosure: None

Related Articles:

- When to sell my dividend stocks?

- Should you re-invest your dividends?

- Dividend Investing vs Trading

- MLPs for tax-deferred accounts