7 Habits of Highly Effective Dividend Investors
Dividend investors come in all different shapes and sizes. Some of us are leaning on dividends to fund part of our retirement, while others are investing for long-term income growth and capital appreciation.
Regardless of our objectives, we are united by our desires to reduce risk and make responsible investment decisions.
However, even the best of us have fallen into traps over the years.
For example, numerous academic studies have shown that individual investors are incredibly poor at trying to time the market and are prone to letting their emotions get the best of them.
Investors pulled $16 billion from U.S. stock funds in 2009 while stocks were at their lowest prices in a decade, according to Bloomberg article citing a Morningstar report.
Another Morningstar report found that “over the 10-year period ended December 2015, investors cost themselves from 0.74% to as much as 1.32% per year by mistiming their purchases and sales…”
If we are not careful managing our emotions, expectations, and investment processes, there can be severe consequences.
The following seven habits can help us become more effective with our dividend investing and reduce the number of avoidable mistakes that are otherwise waiting to trip us up.
1. They stick with what they know
Ted Williams is in the National Baseball Hall of Fame and well-known for the .406 batting average he posted in 1941. He was the last major league baseball player to hit over .400 in a season, and his career on-base percentage of .482 is the highest of all time.
What was behind Ted’s success at the plate? Besides his work ethic, discipline, and exceptional eyesight (Ted avoided movie theaters growing up to protect his vision), Ted was an extremely disciplined hitter.
He divided the strike zone into 77 baseball-sized cells and studied which cells he was best at hitting.
Armed with this knowledge, Ted would only swing at pitches that were thrown in one of his best cells to maximize his chance of getting hits and reaching base.
What does this have to do with dividend investing? We are thrown thousands of pitches each day in the form of dividend-paying stocks.
Our job is to identify our own “cells” that maximize our chance of hitting our investment goals (pun intended).
Of the 10,000+ publicly-traded stocks out there, I estimate there are only a few hundred that I would ever feel comfortable owning in my portfolio at the right price.
There are thousands of companies and dozens of industries that are too complex or unstable for me to get interested in.
Buying these types of businesses that are outside of my circle of competence would be pure speculation and a silly way to lose money.
Unlike Ted, we don’t have to worry about striking out as we wait for our pitch. Disciplined dividend investors have the luxury of waiting for the market to throw a fastball in their wheelhouse.
It doesn’t matter if you are investing in stocks, bonds, funds, or real estate. Perhaps the best investment habit to form is only investing hard-earned money in ideas that are simple to understand and play to our strengths.
There are thousands of fish in the sea, and we only need a couple dozen companies to build a high quality dividend portfolio. Don’t settle.
2. They think independently and conduct their own research
One of my favorite investing books is The Little Book of Behavioral Investing. It states many truths that I witnessed firsthand when I worked as an equity research analyst.
Perhaps one of the greatest misconceptions is that stock “experts” are usually successful with their predictions and know what they are talking about.
Here are some fun stats from the book:
- The consensus of economists has completely failed to predict any of the last four recessions (even once we were in them)
- When an analyst first makes a forecast for a company’s earnings two years prior to the actual event, they are on average wrong by 94%
- At a 12-month time horizon, they are wrong by 45%
- When looking at five-year growth forecasts, the stocks analysts expect to grow the fastest actually grow no faster than stocks they expect to grow the slowest
- In 2008, analysts forecasted a 24% price gain, yet stocks fell 40%
- Between 2000 and 2008, analysts hadn’t even managed to get the direction of change in prices right in four out of nine years
Investing is clearly filled with a lot of uncertainty and randomness. Independent thinking is incredibly important.
Rather than spew out bullheaded recommendations (no one should ever be overly confident about any investment), I do my best to present balanced, objective analysis in my company research to help investors save time and make better informed decisions.
I strongly encourage everyone to reach their own conclusions and ultimately own their decision-making process.
It is human nature to choose the path of least resistance and externalize decisions filled with uncertainty (i.e. investing) to self-proclaimed “experts” who make us feel comfortable.
More often than not, however, this is simply a false blanket of security (and often a very expensive one).
Blindly buying from some guru’s list of best stocks or trading on an idea you heard from your neighbor without doing any of your own diligence is highly irresponsible.
Research tools and data are widely available and affordable today. Use these sources of information to form your own opinion on the quality of a company and whether or not it appears to be reasonably priced.
Spend enough time upfront to decide if this is a company that you would be happy to commit your hard-earned capital to for the next decade.
If you are unwilling or unable to commit a reasonable amount of time to research a stock, then dividend ETFs could be a better choice.
At the end of the day, the most effective investors realize the importance of thinking on their own and following a process that aligns with their goals – regardless of what the stock “experts” are saying.
3. They play the long game and let market volatility work for them
I get a lot of emails from folks who have been sitting on the sidelines for the last few years and want to earn a return on their cash.
However, they worry about the market’s current level and don’t want to risk their capital if a bear market is around the corner.
New money should only be invested when high quality, reasonably priced investment opportunities are available, in my view.
Just because the stock market appears to be somewhat overvalued relative to historical standards doesn’t mean there aren’t any attractive stocks in the market.
Repeatedly trying to time the market is a stressful game to play and has been proven to be more harmful than helpful to investors’ performance (and psyche).
Instead, it’s better to continue scouring for value and commit to a buy-and-hold strategy from the beginning.
While Warren Buffett’s cash position does rise and fall based on market conditions, his portfolio is almost always nearly fully invested in the market.
When he buys a company, he truly plans to hold it forever – through bull and bear markets, economic recessions and expansions – and understands that time is the friend of the wonderful business.
He wastes no time or energy wondering where the market will go next.
Stocks are highly volatile investments, and investors must understand this when they buy shares of a company.
Truly anything can happen over the course of a year or two. No one knows where the market will go, but an effective dividend investor understands this and is emotionally and financially prepared to weather any potential storms.
The Vanguard Dividend Growth Fund (VDIGX) summed up the reality of investing in stocks quite well:
“In general, such funds are appropriate for investors who have a long-term investment horizon (ten years or longer), who are seeking growth in capital as a primary objective, and who are prepared to endure the sharp and sometimes prolonged declines in share prices that occur from time to time in the stock market. This price volatility is the trade-off for the potentially high returns that common stocks can provide.”
Even the strongest businesses will experience meaningful slumps in their stock prices over the course of several days, weeks, months, or even years.
Whenever one of my holdings experiences a material decline (e.g. 10%+) in stock price, I review why the stock is down.
If the weakness is driven by factors that I believe are transitory (e.g. a temporary shift in market sentiment; volatile commodity prices; unseasonable weather patterns; quarterly earnings missed by a penny), I could be tempted to add to my position.
If I had to guess, this is the case nine out of 10 times. After all, it’s unlikely that a major new risk would surface shortly after I have thoroughly researched a company.
As long as my long-term thesis remains intact and the stock’s valuation is not excessive, I will continue to hold and play the long game.
I don’t like to sell my stocks and am a firm believer that trading activity is the enemy of investment performance.
Referencing The Little Book of Behavioral Investing again, individuals who traded most frequently (22% monthly turnover) averaged annual returns less than 12% from 1991 through 1996 compared to the market’s annualized return of 18%.
However, investors with the lowest turnover managed to earn almost 18%. Men are most at risk of being over-optimistic and over-confident, according to group studies mentioned in the book.
The Vanguard Dividend Growth Fund understands the importance of long-term investing.
Wellington Management Company manages the fund, and I had the privilege of meeting with some of the members of their research team in 2015.
Wellington’s investment process is extremely thorough and intensive. My impression was that they truly think like business owners and invest for the long term.
The Vanguard Dividend Growth Fund’s turnover of just 26% reinforces this point and indicates that the portfolio holds a stock for an average of about four years.
While that might not sound like a long time to some of our readers, managed mutual funds have an average turnover rate of roughly 85%!
They basically hold their stocks for less than a year on average. Talk about playing the short game, which is in part driven by clients’ unrealistic demands for consistent outperformance on a quarterly or even monthly basis.
Stock prices can do anything over the course of 12 months. However, over long periods of time, prices follow underlying earnings.
The best companies rise to the top over the course of 5 to 10 years as they continue compounding in value.
The next time you are considering selling a stock solely because its price has decreased, you might want to think twice.
Try to understand why it is down in price and whether or not its long-term value has changed. Remember that prices will almost always be more volatile than fundamentals and invest accordingly.
4. They maintain reasonable expectations
Like any industry, the financial services world has its share of good and evil characters.
The good ones are usually quiet, humble, and rooted in reality. They tell it how it is and are realistic about how much luck and randomness is involved in investing.
Consistently beating the market is next to impossible (especially after management fees), and there are very few “sure things” in investing.
I’ve said it before, but even the “best” fund managers are wrong 40%+ of the time with their stock picks.
Unfortunately, there are a lot of predators out there as well that are looking to devour the next uninformed investor that visits their site or hears about their service.
They make promises of market-crushing returns, boast about their unbelievable performance in recent years, or recklessly push high-yield stocks that they proclaim to be safe – with little supporting research or personal investment behind their recommendation.
Effective dividend investors are aware of these gimmicks and have no interest in wasting their time chasing a fantasy.
The stock market is meant to preserve and moderately growth wealth and income over time – not to get rich quickly.
Individual dividend investors recognize that their odds of beating the market are slim. Instead, they focus on what they can control to meet their own investment goals.
They know that building up a conservative portfolio of blue-chip dividend stocks for the long term should deliver rising income and moderate capital appreciation over the course of many years.
Whether or not they beat or trail the market one year or another doesn’t really matter. Over time, their strategy should deliver growing income, rising stock prices, and potentially lower volatility – without needing to pay money managers high fees or lose control of their nest egg.
Different types of stocks go through cycles of outperforming and underperforming based on market sentiment and numerous unforecastable macro factors such as interest rates.
These cycles can last anywhere from several weeks to several years. Once again, effective dividend investors understand that their approach will go in and out of favor, but that won’t cause them to change course.
5. They acknowledge the importance of total return and resist chasing yield
Interest rates remain depressed and even negative in some parts of the world.
Unfortunately, many retired investors have had no choice but to forego traditional fixed income investments in favor of higher-yielding dividend stocks to meet their income needs.
The temptation can be great to snap up shares in high yield stocks. After all, the math is pretty simple on paper – a stock yielding 8% pays me twice as much annual income as a stock that yields 4%. My money can work twice as hard for me!
While this logic sounds good in theory, it completely ignores differences in risk between stocks.
The old saying, “There is no such thing as a free lunch,” often applies to high yield stocks.
High dividend yields are often a distress signal. As business conditions deteriorate, cash flow declines and the stock price follows over time (sometimes rapidly).
If cash flow shrinks enough and a company is caught unprepared, the dividend often proves to be discretionary.
Buying a stock yielding 8% does an investor’s portfolio little good if the stock’s price goes on to decline 30% or more and the dividend is slashed.
My general rule of thumb is that investors can usually secure safe and growing dividend income by targeting stocks with a yield between 3-5%.
Stocks with yields over 5% can begin to get very hairy. They often have some combination of complicated business and tax structures (e.g. REITs and MLPs), depressed business fundamentals, stretched balance sheets, or other critical issues that potentially jeopardize the dividend’s safety.
While yield is a very important part of retired income investors’ goals, the most effective dividend investors realize the significance of total return and capital preservation.
Total return measures the change in a stock’s price, plus any dividends paid.
The idea is to maximize current income as much as possible without jeopardizing a portfolio’s total return prospects or permanently risking its capital.
Protecting and growing a portfolio’s value creates greater flexibility down the road.
For example, suppose an investor sees his portfolio increase from $1 million to $1.3 million over the course of five years (roughly a 5% annual return) and targets annual dividend income of $40,000.
To achieve his dividend income goal in year one, he needs to target a 4% yield (4% x $1 million-= $40,000).
If he desires for his annual income to grow 2.5% per year to keep up with inflation, he would require just over $45,000 in annual dividend income in five years.
With a portfolio valued at $1.3 million, he now only needs a dividend yield of 3.5% to hit his goal.
Since he can now afford to live off of dividend stocks with lower yields, he could decide to de-risk his portfolio even further to sleep better at night (many companies with lower yields have very safe, faster-growing dividends).
Simply put, a higher total return means more capital, which can be used to generate higher dividend income or safer dividend income in the future. It also leaves more to be passed on to the next generation.
Many high yield stocks have very uncertain futures and could even go bankrupt. A portfolio filled with risky high yield stocks could fare well for a period of time, but there is real risk of permanently losing capital in some of these investments.
Sticking to blue-chip stocks that have time-tested operations, numerous opportunities for long-term earnings growth, and proven dividend growth track records can help lower a portfolio’s volatility, improve its total return outlook, and provide greater optionality down the road.
While high yield stocks aren’t untouchable, investors know to approach them with great caution. Never assume their dividends are risk-free.
6. They stay informed but don’t over-manage their portfolios
I recently read an investor’s tweet that said he was watching his holdings everyday on practically an hourly basis.
I almost felt exhausted just from reading his message, but I believe his portfolio management techniques are probably not all that uncommon – especially for newer investors.
With unrealized gains and losses swinging throughout the day and impacting one’s net worth, it can be quite captivating to watch a portfolio very closely.
After all, the pundits on CNBC and other media outlets overanalyze every tick up or down in a stock’s price and love to make a big deal of short-term events (e.g. quarterly earnings) that really don’t impact a company’s intrinsic value in most cases.
Not knowing any better, relatively new investors sometimes perceive these financial talking heads as “experts” and often follow their lead to over-manage their investments.
In fact, it’s only human nature to feel an urge to do something, anything, in most situations.
Take soccer, for example.
According to The Little Book of Behavioral Investing, soccer penalty kicks are distributed 1/3 left, 1/3 center, and 1/3 right.
The goalie dives left or right 94% of the time, doing his best to use his “guessing” abilities to anticipate the direction of the kick and block it (there is extremely little time to react – the average kick reaches a speed of 70 miles per hour and is shot just 36 feet away).
However, the goalie’s save rate is the highest (60%) when he stays in the center of the net.
In other words, he would be much better off not moving at all (at least until opponents caught on) but only does this 6% of the time.
Managing a dividend portfolio isn’t much different.
Rather than hopelessly diving left or right trying to predict which of our stocks will appreciate the most over the next week, month, or even year, our focus needs to be on owning high quality businesses and giving them as much time as possible to compound in value and grow dividends.
Many times we are better off if we keep things simple and “set it and forget it.”
Watching daily stock price gyrations is really an obsessive behavior that I believe causes far more harm than good and is misaligned with long-term investing.
Stock prices are inherently more volatile than underlying business fundamentals.
We sometimes forget this truth thanks to our overwhelming desire to seek comfort, which can tempt us to sell near-term underperformers and miss the long-term picture.
Rather than micro-managing every little price movement in our portfolios, effective dividend investors maintain a healthy balance of periodically monitoring new developments with their holdings and focusing on the long-term outlook.
Choose your stocks carefully and plan on holding them for many years, if not forever. With this mindset, the temptation to check in on things daily begins to dissipate.
I spend at least a few days (or even weeks) upfront researching a company to determine if it’s a business I would like to hold forever.
If my research checks out and the price is reasonable, I will add the stock to my portfolio.
To stay informed and make sure nothing has changed with my long-term thesis, I skim the company’s quarterly earnings reports during the year.
Otherwise, I am content letting it ride and largely ignore any day-to-day price gyrations.
Price volatility doesn’t cause me to lose any sleep at night when I remain confident in the underlying business quality of my holdings.
7. They have enough financial literacy to make informed decisions
Warren Buffett hammered home this point best:
“You have to understand accounting and you have to understand the nuances of accounting. It’s the language of business and it’s an imperfect language, but unless you are willing to put in the effort to learn accounting – how to read and interpret financial statements – you really shouldn’t select stocks yourself.”
You don’t have to be a rocket scientist or CPA to responsibly invest in dividend-paying stocks, but buying stocks without understanding anything about financial statements is reckless behavior.
Cash flow statements, balance sheets, and income statements communication extremely important information about the health of a company and the safety of its dividend.
Fortunately, investors do not have to dig through hundreds of pages in annual reports to get the critical information they need to make better informed decisions.
Financial data is widely available on the web today, and many of our tools show the most important dividend, fundamental, and valuation data you need to know for a company on one page. This tool helps income investors thoroughly assess a firm's quality in an efficient manner.
Dividend Safety Scores also do the heavy lifting by analyzing a firm’s key financial statements and ratios to assess the safety of its dividend.
While these shortcuts are convenient and helpful, investors should absolutely understand the basics of financial statements before buying any shares of stock.
Closing Thoughts on the Best Dividend Investing Habits
Investing isn’t easy, but there are a lot of bad habits that can make it much harder and costlier than it needs to be.
By remaining inside our circle of competence, staying calm through inevitable bouts of market volatility, focusing on the long term, and staying reasonably educated and informed, many mistakes can be avoided.