A couple of interesting posts showed up recently from fellow bloggers that are worth discussing and I find them very pertinent to defining what your investing strategy is. Here are the quick points that highlight the content which is comparing a dividend investing post with a simple index growth-oriented strategy.
- The Top 5 Things You Need To Know About Dividend Paying Stocks @ My Own Advisor
- Dividends provide an immediate return
- Your safety buffer against the worst case scenario
- Dividends increase over time
- Dividends have a long history of being paid
- Dividend yield can help you determine when to buy
- Things You Need To Know About Selling Stocks @ Michael James On Money
- Selling 5% of your stocks each year provides an immediate return
- Safety buffer against the worst case scenario.
- The value of that 5% increases over time
- Many businesses have a long history of rising share values
In short, Michael James is having a little bit of fun at the dividend investor. It’s all in good spirit. However, the points mentioned were also used by the Canadian Couch Potato in his ‘Debunking Dividend Myths’. The point highlighted by both is that a company that re-invest its cash will see growth and therefore an increase in value whereas a company that pays a dividend removes value from the company and should expect the stock price to go down. That’s why Michael James says you can just sell 5% of your stock if you really want a dividend. While I agree with the basic theory of a company valuation, in practice the valuation is not that simple unfortunately and stock prices don’t just move based on that valuation. There are so many factors that can impact the stock price (the immediate stock valuation) such as the economy, the geopolitical situation, or even natural disasters. It’s true that the stock price doesn’t always reflect the true valuation of a company but the profit and losses of an investor are based on the stock price of when you buy and sell.
There is one point that fails to compare with dividends (as mentioned by Dividend Ninja in the comments); if you just sell 5% to create income you can’t really replicate the DRIP aspect of dividend investing. DRIP allows an investor to add to their stock and often times at a discounted price. If you were to sell 5% and buy back the same share worth 5%, you essentially have a net 0 gain whereas dividend DRIPs have an actual gain. Not to mention that DRIP don’t have any transaction fees and you get a discount from many companies.
As much as the fun was around some points made about dividend investing, a strategy is what you need to define before you just invest in anything. Whether you sell 5% of your stocks every year to generate income or invest in dividend stocks or follow the index investing path, you need to define your strategy and follow through with it. I have discussed why I invest in dividends and I’ll cover what makes it a strategy for me. I wrote for me by the way :) I can share though but it’s important you all define your own strategy.
Defining Your Investing Strategy
Just investing in dividend stocks doesn’t make it a strategy. The same goes for buying index funds or dividend ETFs or anything else. The strategy you want to follow should be based on the goals you want to reach. It’s only a means to an end. In practically all cases, a strategy requires time and patience to execute and see the results. My goal is to generate sustainable income from which I can retire from. I want to avoid touching the capital and depleting it. It can be done since my parents have been doing it for over 25 years and most of it invested in preferred shares.
My dividend strategy provides me with the ability to invest without stress and with guidelines by which I can more easily evaluate my investments over time. Here are some guidelines I have set for my strategy (you can see my dividend stock screening as a guide).
These are the numbers I evaluate from a quick glance at my accounts to review my investments. These can create warning signs and as you can see, only a dividend paying company can have the top 2.
- Dividend Yield: Too high a yield is a warning sign
- Dividend Payout Ratio: Too high a ratio compared to peers is a warning sign
- P/E: Too high a P/E is a sign of speculation and the stock may have to pull back
- Hold an economic moat for their industry
- Target large companies
- Target companies in business we are dependent on
- Consistent dividend growth (this is the compound growth magic)
- Debt levels based on their industry
A Strategy For The Right Time
It’s also important to adjust or change your strategy for the different stages of your life. I don’t believe there exists one strategy to fit all situations. As you can see, with my Defined Contribution plan, I follow the index investing formula. Not because I think it’s better than dividend investing (I would much prefer to do dividend investing and generating dividend income) but because that’s what make sense for the benefits I get.
I have both strategies in progress and I can tell you that I see more consistent growth in my dividend investing portfolio than I do in my index investing. It’s probably because index investing need way more time to shine but my growth is compounded with dividend investing. My share numbers grow little by little without lifting a finger. My index investments don’t show any compound growth at all. Even if the stock markets over a 100 year period show a compound growth curve, it doesn’t imply that you will get compound growth in the timeline you invest. Theories and practice are very much different.