The article, Overcoming 3 Bad Investing Behaviors, outlined some common bad investing behaviors: stock market avoidance, insufficient diversification, and inefficient trading. I'm going to quote from this article and explore from a dividend growth investing standpoint on how to counter those behaviors.
1. Stock Market Avoidance
Behavioral finance studies have found that investors are roughly twice as sensitive to losses as they are to gains.
Using a dividend growth investing strategy, you're receiving a growing income from your dividends even in a market downturn. Focusing on the dividends you're earning per quarter helps mitigate the sensitivity of paper losses.
People tend to evaluate gains and losses over a relatively short time horizon that may not be in sync with the longer horizon over which investment goals are expected to be achieved. This extreme fear of losses in the near term, combined with people's tendency to look at each investment in isolation, helps to explain low stock market participation rates.
It is common practice for dividend growth investors to estimate how much dividends they will be receiving in the coming year. For example, one could make an estimation based on the current yields of the holdings. For illustrative purposes, let's say we have 100 shares of each dividend grower in our portfolio. This portfolio has 10 holdings. These blue chips are commonly found in dividend growth portfolios. They are Aflac (NYSE:AFL), AT&T (NYSE:T), Chevron (NYSE:CVX), Coca-Cola (NYSE:KO), Darden (NYSE:DRI), Intel (NASDAQ:INTC), Johnson and Johnson (NYSE:JNJ), McDonald's (NYSE:MCD), Raytheon (NYSE:RTN), and Walmart (NYSE:WMT).
|Ticker||# Years||Price||Yield||DGR: 1Yr||3Yr||5Yr||10Yr|
* Price and yield as of Feb. 8, 2013 (from Google Finance)
* Number of years of dividend growth and dividend growth rate data from The DRIP Investing Resource Center by David Fish
Without taking into account the dividend increases this year, we'd receive a total of $1982.07 in dividends or a yield of 3.28%.
Focusing on the dividends we are to receive this year, the uneasy feeling of short-term price fluctuations should be reduced. Thinking about these companies' growing dividends also helps with a long-term outlook instead of a short-term one.
As long as the earnings remain intact for these companies, we can expect their dividends to grow in line with the ranges above (1yr to 10 yr dividend growth rates). It's exciting to note that the dividend growth rate of the portfolio will grow faster than the rate of inflation, so that our purchasing power will increase for the future. In addition, as long as their dividends continue to grow, we can expect the price of the security to continue to grow in the long-term. Because the stock price also steadily appreciates in the long-term, we won't see (ridiculous) yields of 10% for any one of these companies, even though some have been increasing their dividends for 50 years.
2. Insufficient Diversification
Another common investor mistake is to have an under-diversified portfolio. In a 1991 to 1996 study of the customers of a large US discount brokerage, more than 25% held only one stock, and more than 50% held three or fewer stocks. However, a well-diversified portfolio should include at least 10 to 15 stocks, which only 5% to 10% of the investors held in any given period. And generally speaking, the more diversified portfolios performed better: the most diversified investor group in the study earned more than 2% a year higher returns than the least diversified group.
Some experienced investors showcase and update their dividend growth portfolios on Seeking Alpha. David Van Knapp and David Crosetti come to mind. We will always find at least 10 to 15 stocks in these portfolios. In each sector, it is not difficult to find the top companies which also grow their dividends annually. The harder part is to catch these companies when they're at fair or lower valuations. Because these companies are high quality, most of the time, they're priced at a premium.
Behavioral finance concepts behind this mistake include investors' tendency to use certain rules of thumb (for example, dividing assets evenly into funds) for allocation decisions, and to opt for familiar home-market stock names that can be recalled easily.
It's fine to invest with equal weightings on recognizable names as long as one has done their research. That is, buying companies at reasonable valuations, knowing that the earnings of these companies is generally trending upwards, knowing that they have manageable debts, and the fact that these companies have been growing dividends for a number of years doesn't hurt either. Realistically though, usually one can find better value after a sector has pulled back, and sectors take turns pulling back. Thus, during the accumulation phase, I find it's much more beneficial to the investor if they bought into companies gradually, particularly companies that have experienced an obvious pullback, and is therefore, at more enticing valuations, compared to the strategy of going all in just for the sake of starting to collect dividends. As a result, one might have one or two companies to start, but aim to diversify into more companies and sectors overtime as opportunities arise.
3. Inefficient Trading
Many investors tend to move in and out of positions in an inefficient way, reducing their potential profits. This may be because individual investors are often overly confident in their own abilities to beat the market, and thus trade excessively and hurt their portfolio performance.
With dividend growth investing, it's obvious that one needs to hold the shares to collect the dividends. As a result, dividend investors won't trade excessively in fear of missing out on a dividend. If one decides to sell and take capital gain, they might not be able to get back into the security at the original buy price or at a lower price. So, the solution is not to trade the stock, but invest in the company with a long-term view.
Investors also often make the cognitive mistake of extrapolating from past returns, buying assets whose prices have gone up in the expectation that prices will continue to increase.
Many dividend growth investors are also value investors. These investors will not chase winners unless the winner is still at proper valuations.
At the same time, people tend to be more likely to get rid of stocks that have done well in the past, and to keep the losers so as to avoid the mental pain associated with realizing losses.
Similarly, dividend growth investors who are also value investors will not get rid of winners solely because they had done well. On the other hand, if these winners become ridiculously overvalued, then, maybe they would sell them or at least rebalance the portfolio so that overvalued holdings have less weight. Likewise, these investors would not keep the losers unless their fundamentals remain intact.
Dividend growth investing is not the be all and end all strategy, but combined with buying solid companies at reasonable valuations, and the fact these companies increase their dividends annually, it is a powerful force that helps to inhibit the bad investing behaviors of stock market avoidance, insufficient diversification, and inefficient trading.