Estimated reading time: 11 minutes. Yes, this is a long article, but it is a critical read if you want to become a successful long-term investor.
“The single greatest edge an investor can have is a long-term orientation.” Seth Klarman
The number one reason to be a dividend growth investor is that it is a strategy that you can stick with LONG TERM. What, not the sexy answer you were expecting? My guess is that you were expecting it to be that the strategy outperforms the index (Either the Canadian Toronto Stock Exchange Composite Index or US S&P 500 index). A good guess, and I could even show you a wonderful looking chart of dividend aristocrats (Companies that have a history of increasing their dividend each year) vs. the benchmark index like this:
Here’s another since we’re on a roll:
Isn’t it nice how the lighter blue line has increased more than the dark blue line in those first two charts … dividend growth investing must be best! While it’s true that dividend growth investing has a history of providing higher returns than the benchmark (Also with less volatility), this doesn’t make it the #1 reason.
Just because a strategy has a history of beating an index doesn’t mean it is the best strategy for YOU. For almost any legitimate investment strategy to work you need to give it time, ideally, you want to be thinking in terms of decades. This is true whether you are a dividend growth investor like me, or any other type of investor (Value, Index, growth, etc.).
To be a successful investor of any kind (Not just dividend growth investing) you need a long-term mindset to reduce risk.
Source: The Single Best Investment: Creating Wealth with Dividend Growth by Lowell Miller (Affiliate link, but I personally own and highly recommend this book.)
The longer you hold stocks the lower your risk of negative returns. This means you need a strategy that you can stick with for decades. This is where dividend growth investing really shines through compared to other strategies.
The #1 reason to be a dividend growth investor is that you can stick with the strategy long-term. That way you are able to take advantage of long-term market returns. Dividend growth investing is better aligned with investor behaviors than other strategies as it is a common-sense strategy that provides natural coping mechanisms for the tough years.
Stock Market Crashes – Can you handle it?
“You shouldn’t own common stocks if a 50% decrease in their value in a short period of time would cause you acute distress.” Warren Buffet
Think about all the crazy things that have happened in the stock market in the past 20 years. Now try to think about how you’d react in those situations when times truly got tough. That might be putting it a little mildly…
When $h!t hits the fan and your portfolio has just lost 50% of its value how are you going to feel and react? In this type of crazy negative environment, will you be able to stick with your investment plan?
Really try and answer these questions honestly and take a minute to think about it.
I’ll ask you again, in a hypothetical (But plausible) crazy negative environment where your portfolio just lost 50%, will you be able to stick with your investment plan?
If no? … Then you’ve picked the wrong strategy and you should try and find a strategy that better suits your personality.
If yes? … Great … another question for you:
Have you actually experienced a real gut-wrenching loss from a major stock market crash? (We aren’t talking hypothetically anymore)
If you have then you can keep your answer as Yes, but if you haven’t then your answer is now a Maybe. Until you’ve actually experienced a true stock market crash you won’t really know how you’ll react. It’s one thing to fill out a risk tolerance questionnaire and think you’ll know how you’ll react, another to actually live through it.
Only after you’ve lived through a gut-wrenching stock market crash will you truly know if you have the stones to stick with your investment plan. If you haven’t lived through a big crash, that’s OK. You just have to try and figure out the best strategy to fit your investing psyche and then build in fail-safes to protect you from yourself so that you can survive these events.
“The investor’s chief problem – and even his worst enemy – is likely to be himself.” Benjamin Graham, The Intelligent Investor (Affiliate link)
Investors often don’t spend enough time truly imagining how they’ll feel and act when the going gets tough. I’ve provided an example that should hopefully help with this. By the end of the example, you should be able to see how dividend growth investing has natural fail-safes built into its strategy that should help you navigate the truly scary investing periods.
The Lost Decade Case Study: John the regular investor vs. Mary the dividend growth investor
For this example, I’m assuming that both John and Mary will experience roughly the same returns on their journey. In reality, I’d expect Mary to outperform John. The point of this exercise isn’t that dividend growth stocks typically outperform the index, it is that dividend growth investing as a strategy can help you cope with these losses better so that you can hang on during the absolute worst and enjoy the subsequent recovery having survived.
Knowing that you’ve outperformed or expecting outperformance isn’t enough for some investors to stick with it through market crashes. When there is a serious market crash EVERYTHING DROPS. Even if you are outperforming the index you are still losing money. For instance, instead of losing 50% like the index you only lose 40%. The pain you’ll feel at losing 40% will be comparable to losing 50%. Sure, it’s nice you didn’t lose as much money, but you’ve still lost a lot and it is the feeling of loss that is going to cause you to do something irrational … like, sell your investments at exactly the wrong time.
We are trying to find you an investment strategy that will remove or at least temper these irrational actions. Hopefully, by following along in John and Mary’s journey through the lost decade you’ll be able to better identify a long-term investment strategy that works for you.
OK on to the example…
The lost decade
I wanted to pick a particularly awful 10-year period for this example and decided on the US’s lost decade (2000 to 2009). Below is the 10-year chart of the US S&P 500. Ugly right?
Take a look at this chart and try and imagine how you’d react each year along this chart. How would you have faired and what actions would you have taken on this journey?
I’ve chronicled the journey of John (Our regular investor) and Mary (Our dividend growth investor) to better illustrate the importance of finding a strategy that you can stick with when your portfolio is suffering losses and serious doubt starts to creep into your mind.
Meet John & Mary
John decides just to buy the S&P 500.
Mary is a dividend growth investor and knows to focus on financially strong companies with a history of increasing their dividend each year. She invests in companies with a sustainable reasonably high dividend yield.
She usually wants a dividend yield of at least 2 times (2x) the market dividend yield but is willing to go to one and a half times (1.5x) the market dividend yield for the right stock. Under normal circumstances, she usually looks for a dividend yield of 4% or higher, but these are not normal days as the S&P 500 in January 2000 is currently yielding a low 1.2%. Finding good dividend growth candidates at the 4% dividend yield level is unrealistic in this market so she focuses on companies that are 2x the market dividend yield, or companies with a dividend yield of 2.4% or higher. She focuses on reasonably valued financially strong companies with a history of increasing their dividend for 10 or more years in a row and it turns out that her investments grow their dividends by 6-8% per year over the next decade.
Both start investing in January 2000.
Mary & John’s thoughts and actions throughout the years
2000 – Down 20%
2000 Starts out alright for John and Mary, but by the end of the year, they are about 20% down. Both are worried because 20% is a lot of money to lose. Luckily, they know to stick with it, as investing is a long-term game with big ups and downs along the way. In the long run, it should work out.
2001 – Flat year
2001 is a flat year, but this is alright with John and Mary because they know these things take time, hopefully, next year is up.
Mary notices that her investments are paying her slightly more in dividends this year, cool.
2002 – Down year
2002 comes and goes and it turns out 2002 was a down year too. Both are now down about 35% total. Mary and John are three years into this strategy and have serious worries that they might have picked the wrong strategy. Doubt has been creeping in for a while now, but more so for John.
Mary is doing a bit better because she has noticed that for the past 3 years her investments have increased their dividends each year and she is now receiving a 2.9% to 3.0% yield on cost compared to her starting dividend yield of 2.4%. It’s not a huge increase, but she is tracking the dividends more closely now as it brings her comfort to know that her investments keep raising the dividend each year. The companies must be doing something right if they are able to keep increasing their dividend.
Both Mary and John know it is a long-term plan, but the pain of losing this much money is causing serious doubt. John starts to think maybe he isn’t cut out for this.
2003 – Up year
2003 comes just in time for John as he; along with Mary, finally has an up year. It’s a good thing too because John nearly sold everything in a panic one day back in 2002. Luckily cooler heads prevailed.
John and Mary are still down about 20% total, but this is a big improvement from 2002 when at one point they had lost around 45%. That made them both very nervous.
2004 to 2006 – Mostly flat or up
2004 to 2006 are mostly flat or small up years, with the big improvements coming in the 2nd half of 2006. Up until this point John had regularly debated switching strategies a number of times as he had a few friends that seemed to be doing much better than him and it wasn’t until the end of 2006 that he FINALLY got back to 0%.
Mary at this point is happy that the stock market is improving, but her focus has shifted drastically over the years to the financial health of the companies she is invested in and the growing dividend income she has now come to expect from them. Every dividend increase announced is a sign from management that the business is OK and continuing to grow over the long-term. She enjoys reading about her annual dividend increase announcements from the various companies she owns. She’s been impressed that they’ve managed to increase their dividend by 6% to 8% as this is more than her annual salary raises at her own job! She is now receiving a 3.6% to 4.1% yield on cost compared to her starting dividend yield of 2.4%.
2007 – Down year
At the beginning of the year John just barely decides to stick with it as he debates getting out at 0%. It’s been over 7 years with very little to show for it and the stress of his investing strategy has slowly eaten away at his resolve. He could have just bought a GIC back in 2000 and had better returns with way less stress.
John hangs in there though and later in the year feels like his decision was validated as his total return gets a little over 5% for the 1st time in 7 years. Unfortunately, the market starts to drop and by the end of the year, both John and Mary are back in negative territory at around minus 10%. At this point, John is very close to breaking as it has been almost 8 years and he still has negative returns. If next year doesn’t turn out better he isn’t sure what he’ll do.
Mary continues to watch her dividends grow, but in the back of her mind, she does worry from time to time that these total returns are historically quite low.
2008 – Large down year (Start of the financial crisis)
This turns out to be a horrible year and it’s the year that finally breaks John. When the market seems to be in free fall and there is negative news everywhere John makes a hasty decision to sell everything at roughly a 30% total loss. The market continues to drop and John feels he has made the right decision but is still bitter about the major 30% loss.
Mary is earning a yield on cost of around 4% to 4.8% now which is almost double her initial 2.4% dividend yield. She is amazed that her dividend income has almost doubled as it wasn’t something she thought much about at the beginning. Now that almost 9 years has passed she is really seeing the power of compounding dividend increases. What started out as small is now having a larger impact. She is holding onto this information as validation that her strategy will work in the long-term.
While this information provides her some comfort, she is still very nervous. The market seems to have no bottom. She is watching her investments like a hawk but is still surprised to see that most of them are increasing their dividends still. She has noticed that a few companies didn’t increase their dividend near the end of the year. She is monitoring these companies. Despite the market craziness, she manages to hang in there.
2009 – Up year
John didn’t make it to 2009, but feels a sense of relief as he could have lost even more money. It still sucks that he lost 30% of his money though. He isn’t sure what the plan is anymore and needs to re-evaluate. Maybe he’ll try something safer?
In a cruel twist of fate, it turns out 2009 would have been one of the best times to invest, but John was so worn down by the prior 9 years that he likely won’t consider stock investing for at least another 5 years.
Mary is able to hang in there another year, but it wasn’t easy. By the end of 2009, the market has gone back up quite a bit and Mary is hopeful that the worst is over. She is now receiving a 4.3% to 5.2% yield on cost compared to her starting dividend yield of 2.4%. In 2009 there were a few dividend cuts announced from some of her companies, a few kept the dividend steady, but most continued to increase the dividend. In fact, the dividend increases more than offset the dividend cuts caused by the financial crisis.
The companies that did cut their dividend she sold and used the proceeds to buy a few other financially strong dividend growth stocks. This time it was easy to find good candidates at 4% dividend yield or higher. She realizes that had she started investing at a more normal time in history when it was possible to find starting yields of 4%, she would have had a yield on cost of 7.2% to 8.6% if the dividend grew 6-8% over the 10 years. Turns out time is the friend of a dividend growth investor.
Moral of the story
Pick an investment strategy that you can truly stick with. Had John stuck with it like Mary did, the chart would’ve ended up looking like this:
The number one reason to be a dividend growth investor is that it’s a good strategy that you can stick with LONG TERM. A successful investing strategy requires long-term focus. For almost any legitimate investment strategy to work you need to give it time, ideally, you want to be thinking in terms of decades.
If you are trying to find an investment strategy that you think you can stick with, then an obvious choice is dividend growth investing as it is better aligned with investor behaviors than other strategies. Dividend growth investing is a common-sense strategy that provides natural coping mechanisms for the tough years. These tough years are the hardest, but most critical to surviving.
Dividend growth investing shifts the focus from stock market gyrations to your growing stream of dividend income. It’s not that you ignore the total return, but it is easier to stick with an investment when you can see that the company is increasing their dividend despite what looks like a turbulent stock market. When the dividend keeps going up, it is a sign that your strategy is working and it’s easier to stick with it even though the stock market might be going nuts.
Yes, dividend growth investing has a history of outperforming the index with better risk-adjusted returns, but it’s more than that. The point of the lost decade case study was that dividend growth investing as a strategy can help you cope with these losses better so that you can hang on during the absolute worst and become a true long-term investor.
Questions for our readers that went through the financial crisis:
- How did you handle it?
- How scary did that feel?
- Any tips for the rest of us on coping mechanisms for surviving a stock market crash?
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