Minimize Losses: Maximize Long-term Gains

"Avoiding serious loss is a precondition for sustaining a high compound rate of growth."  -- Roger Lowenstein, Financial Journalist and Director, Sequoia Fund

Dividend Farming is an investing practice extended into a future horizon.  It’s not a “get rich quick” activity doubling your money in six months, a year, or even two.  It relies upon the reinvestment of dividends to compound growth and that requires time.

If Dividend Farming investments are compounding at 4% annually, how do we expect them to perform better than alternatives that may be enjoying double-digit growth today?  How can I believe that a lowly 4% return will get me where I want to be in 20 or 30 years?  Answering that question means investigating two scenarios.  The first involves a steady-eddy dividend play while the second is a high-flying investment that is volatile over time.

Both examples start with a single share of stock priced at $50.  Each share is held for 20 years.

The stock paying a dividend offers a steady, 4% annual dividend. 

The alternative offers no dividend, but a cyclical trajectory of increases and decreases during the 20-year period.  Within that timeframe the stock enjoys two years of 30% growth, two years in which it declined 30%, two years of zero growth, and the balance at 7% growth which is the historical market average.

Year 0	$   50.00	Annual Growth Dividend Stock	$   50.00	Annual Growth Non-Dividend Stock
1	$   52.00	4%	$   53.50	7%
2	$   54.08	4%	$   69.55	30%
3	$   56.24	4%	$   74.42	7%
4	$   58.49	4%	$   79.63	7%
5	$   60.83	4%	$   85.20	7%
6	$   63.27	4%	$   59.64	-30%
7	$   65.80	4%	$   63.82	7%
8	$   68.43	4%	$   68.28	7%
9	$   71.17	4%	$   73.06	7%
10	$   74.01	4%	$   94.98	30%
11	$   76.97	4%	$ 101.63	7%
12	$   80.05	4%	$ 101.63	0%
13	$   83.25	4%	$ 108.74	7%
14	$   86.58	4%	$ 116.36	7%
15	$   90.05	4%	$   81.45	-30%
16	$   93.65	4%	$   87.15	7%
17	$   97.40	4%	$   93.25	7%
18	$ 101.29	4%	$   93.25	0%
19	$ 105.34	4%	$   99.78	7%
20	$ 109.56	4%	$ 106.76	7%
Advantage	3%

At the end of the 20-year holding period, the dividend paying steady-eddy outperformed the volatile non-dividend payer by 3%.

This is a hypothetical exercise; the kind of which academics are fond.  It’s clean, clear, and unencumbered by things like the real world.  Although neither stock is guaranteed to grow exactly as shown, the exercise is helpful in four ways. 

Dividends Roll Up Over Time

First:  It shows what can happen when a dividend payer with a long history of payments, that is likely to continue, can do.  Moreover, it does so with better forecast accuracy.  Investing in a dividend champion helps reduce your risk.  Firms with growth and decline that cycle unexpectedly and abruptly are difficult to count upon to deliver the returns you need over time.

Second:  The consistent progression of the dividend payer also means that if you need to take money from your investment you’re less likely to do so at a significant low point in the market.  Investments that swing up and down like that of the alternative mean you could be forced to take a distribution during a market decline.  If that happens you may not be able to make up the loss, particularly if your investing horizon is short.

Third:  The average yield during the period for the first investment is 4%.  However, the average yield for the second investment is 5%, yet comes up short.  The reason is that the compounding effect is diluted by the years of large losses.  This is the essence of Lowenstein’s quote above.  If you don’t understand how this can happen, consider this example.

Fourth:  3% outperformance is a win.  Better performance with less risk is what margin of safety is all about.  It may not be glamorous, but who cares?  You still win.  See a couple of the dividend articles linked here for more about the performance of dividend stocks over time. 

Getting to your horizon with the money you need, sleeping soundly along the way, is the essence of Dividend Farming.

The thoughts and opinions expressed here are those of the author, who is not a financial professional.  Opinions expressed here should not be considered investment advice.  They are presented for discussion and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.

Selecting my own stocks… I’ll screw it up, right?

The title states what may be the only thing standing twixt a satisfied DIY stock investor and a person who throws it over the fence to a professional.  Pundits, talking heads, and bold media headlines lead would-be DIYers to believe investing in stocks is rocket science or brain surgery.  It’s not.  It does require effort, but not as much as you think.

Bertrand Russel is recognized as making famous the phrase, “Men would rather die than think.  And most do.”  Dividend Farmers who are value investors and DIYers don’t subscribe to this perspective.  Like regular farming, Dividend Farming requires active participation; consistent and persistent.

An earlier post shared 10 Questions to help you build an investing philosophy.  A philosophy is a good framework with which to start.  Eventually we move from philosophical perspective to the active practice of selecting our first stock.  But how do we do so without screwing it up?

Benjamin Graham, the godfather of value investing offers advice about this in his work, Security Analysis.  In it he summarizes three hurdles investors face when selecting stocks.

First:  Overcoming inadequate or incorrect data.  As a pilot, the phrase, “Good information leads to good decisions,” quickly comes to mind.  Another way to look at is GIGO or garbage in / garbage out.  However you wish to view it, the first thing is to develop solid information.  This means reviewing company data from Yahoo Finance, your brokerage’s online tools, or similarly recognized and trusted sources.  This is the entry point of your selection activity and the first line of risk mitigation.

Dividend Farming: Selecting Investments provides a list of specific steps and resources you may consider in developing your selection information.  Posts about SO, GD, MSFT, UTX, GIS, and DE, offer examples about how information might come together in usable form.  However you do it, take the time to find a method for gathering adequate and correct data that works for you. 

    

Second:  Minimize volatility.  Companies with long records of stable earnings growth are likely to produce similar growth in the future versus companies with abrupt or large-scale fluctuations in market price.  Stable firms with strong histories are less likely to see serious declines as well.  This makes them less risky.  Dividend Champions are great options for minimizing risk and volatility.

 

Third:  Focus on the market weighing machine; not the voting machine.  Weighing a company means assessing its (intrinsic) value.  Voting a company is a popularity contest.  The second is meaningful in high school.  Not so when investing; unless you’re a momentum investor speculator.

 

Focus on value, not popularity.

Assessing a firm’s value usually means estimating the cash it can provide over time (dividends, for instance) and measuring that cash flow against the price the market has voted for the day.  Predicting future cash flows from stable dividend payers is easier than forecasting similar flows from companies with wildly gyrating earnings growth or no dividend payments.  You’ll find yourself focusing on weight versus popularity if you stick with stable dividend payers.

In each case, Graham tells us risk mitigation and margin of safety in our selection process is important.  Graham’s guidance offers a method for selecting our investments without screwing it up.  As Roger Lowenstein said, “Avoiding serious loss is a precondition for sustaining a high compound rate of growth”.  Words of investing wisdom, indeed!

The opinions expressed here are those of the author; not a financial professional.  Perspectives offered should not be considered investment advice.  They are presented for discussion and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.

Dollar-cost Averaging Powers Dividend Farming

Dollar-cost averaging is an integral part of DividendFarming.  It’s a powerful method of growing a great financial crop.  The best part; it’s simple and automatic.

In a nutshell, dollar-cost averaging means contributing an amount of money to your investment portfolio to purchase stock on a monthly basis.  You could also do so quarterly, but monthly is advantageous due to the increased number of compounding periods.  The more the merrier, but I digress.  As an example, you might purchase $100 worth of stock each month and do so irrespective of whether the stock’s price has increased or decreased.

Courtesy of JP Morgan

With dollar-cost averaging you may purchase a few shares at high prices, but you are also likely to purchase more shares at lower prices.  The table below demonstrates the principle using the $100 example mentioned previously.

Month	Share Price	Shares Purchased
January	$25	4
February	$28	3.5
March	$27	3.7
April	$23	4.3
May	$20	5
June	$22	4.5
TOTAL		25

You will have purchased anywhere from 3.5 to 5 shares per month with your $100 investment as long as you were disciplined about putting money into your brokerage account and making the purchase. 

Brokerage Fees and Partial Shares

Realistically, if you were making the purchases with contributions to your account, the stock purchase figures would be lower because you would have paid a brokerage fee each time you made a purchase.  If a broker charged you $5 for each trade, you would be investing only $95 per month to buy stock.  Consequently, the quantity of stock you buy each month would be lower than shown. 

It should also be noted you can’t buy partial shares this way.  This means another portion of your $100 would be unavailable to use for purchases each month.  This money could be held in the account and used to supplement your purchase the following month, but you still miss the full effect of dollar-cost averaging.  The next table offers clarity.

Month	Share Price	Commission Fee	Funds Available	Shares Purchased	Balance
January	$25	$5	$95	3.0	$20
February	$28	$5	$95	3.0	$6
March	$27	$5	$95	3.0	$9
April	$23	$5	$95	4.0	$3
May	$20	$5	$95	4.0	$10
June	$22	$5	$95	4.0	$7
TOTAL				21	$56

In this example, which is more realistic, you would purchase only 21 shares during the same 6-month period versus the previous case.  You would contribute $30 to your broker for the privilege of making the purchases.  An additional $56 of your $600 in investment funds accumulated in the account because you can’t purchase partial shares. 

Based on the purchase prices shown, you would have to accumulate the leftover funds for about 3 months before you could use them to purchase an additional share of stock.  You effectively lost $86 ($30 + $56) or 14.3% of your investment to the broker or the opportunity-cost associated with not being fully invested each month.

Ok, if you lose a large chunk of your investment funds in the dollar-cost averaging example shown, how can that be beneficial to you as a dividend farmer?  When farming dividend stocks, the dividend payments can be accepted into your brokerage account as cash and reinvested in additional dividend stock.  Managing your dividends this way results in the kind of attrition highlighted in the second table.

DRIP Strength

However, if you have your dividend payments automatically reinvested in the companies paying them, you avoid the brokerage fees and you’re allowed to purchase partial shares.  When you receive $600 worth of dividends and reinvest them in a DRIP, you put the full $600 to work for you, compounding all the way, increasing your crop yield.  

This is the true power of dividend reinvestments.  Additionally, you’re assured of automatic contributions to your portfolio each month.  Efficient, disciplined investing maximizing your ability to grow a healthy dividend crop.  Who doesn’t like that?

   

The thoughts and opinions expressed here are those of the author, who is not a financial professional.  Opinions expressed here should not be considered investment advice.  They are presented for discussion and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.