I have not played the board game Risk in about 22 years. My husband is a logical computer programmer who enjoys strategy. Me, well, I simply do not see the point of working that hard to have fun, but I am willing to play along. I happily roll the dice, move my mice and nobody gets hurt. Or, at least, that is the way it is supposed to work. My husband would carefully deploy his armies in crucial places, while I chose countries which appealed to me based on shape, color, or current reading. By mid-game he would be strategically situated to tromp all over my positions. However, he had not factored in my uncanny ability to roll sixes. Game after game, week after week, I would decimate his armies, overtake his carefully planned positions and win the game. It was baffling and frustrating for him and not many months later we gave away our game to preserve our newly-wedded bliss.
Whenever I run into the word 'risk', I'm always reminded of the game and how careful strategy and simple luck can either work together or oppose each other.
One of the surprises for me that came out from the comments section of my recent article, "Is it Worth Holding Cash and Being Patient?" is that underneath all of the opinions, arguments and supporting data were people's views of risk and how that affects their investing behavior. I realized I needed to more fully understand what the underlying risks within Dividend-Growth Investing are in order to create better investment guidelines for confident future decisions, for example, whether to initiate a purchase in Johnson and Johnson (JNJ).
When I first began investing, I held the common view of market risk found in Modern Portfolio Theory, that the more risk you are willing to tolerate the more your gain (or loss) will be. Thus it follows that one should maximize their risk tolerances if they need more gains. I soon discovered that was not always the case, and found my average rate of return in trading larger cap, less risky stocks was much higher with the proportion of successful trades much greater. I have now discarded this common view, after reading Benjamin Graham's very different idea in his book, The Intelligent Investor.
It has been an old and sound principle that those who cannot afford to take risks should be content with a relatively low return on their invested funds. From this there has developed the general notion that the rate of return which the investor should aim for is more or less proportionate to the degree of risk he is ready to run. Our view is different. The rate of return sought should be dependent, rather, on the amount of intelligent effort the investor is willing and able to bring to bear on his task. The minimum return goes to our passive investor, who wants both safety and freedom from concern. The maximum return would be realized by the alert and enterprising investor who exercises maximum intelligence and skill. p 89. The Intelligent Investor.
Risk is directly related to your goals and approach. Something that may be considered a high risk choice for one investor does not necessarily carry this same amount of risk for the next investor. It is difficult to decide what your primary risks are if you don't have clearly defined goals. Even just within Dividend-Growth Investing there are people with different primary goals. Some may still focus on a measure of growth while others focus only on a growing dividend-income stream. Even though their approach may be the same, their goals, situation, and needs may be slightly different. What is considered risk may also be slightly different.
What kinds of risk does a Dividend-Growth investor face and how can we manage it?
1. The most significant risk for a D-G investor whose primary goal is an increasing income stream is the lack of dividends while not invested. This was clearly communicated to me by several commenters in the comments section of my latest article and it is the undeniable primary risk. The easiest and most simple, logical way to manage that risk is to remain fully invested. I should buy JNJ, as one of the top quality DGI companies as soon as I have the funds to buy in as the risk is in NOT owning JNJ and NOT earning the dividends and participating as soon as possible in the growing income stream.
2. For a pure D-G investor, a cut or decrease in dividends is the obvious second risk. For many, simply selling a stock as soon as a dividend is cut is announced deals with that risk. In the process, this avoids many other risks as well. Dividend cuts are often not a surprise to investors. Often there are discussions that a dividend cut is coming. Wise investors watch payout ratios and look for other indicators of threats to their dividends that happen before a cut.
3. D-G investors are fond of saying that price doesn't really matter, but paying too much and not having a margin of safety when entering stock position is the other risk that was most often pointed out in the recent article's comment section. It was the main argument against initiating a position in JNJ. Not being too eager to jump into a position and waiting for a pull-back, or searching for undervalued companies to invest in instead are common remedies to this risk. Dollar Cost Averaging or dividing planned purchases into thirds or quarters can also mitigate this risk. Some felt that despite its high prices, as long as JNJ is not dramatically overvalued, it was still a buy. Others felt that to follow Graham & Warren's philosophy, a company should be significantly undervalued to warrant a purchase.
4. Inflation is a massive invisible threat to our investments. This is where DGI shines. Most companies that would be considered acceptable DGI names increase their dividends at the rate of at least double the rate of inflation. This risk problem is solved by purchasing JNJ.
5. A company's failure to thrive is a risk that all investors take, but since D-G investors are after the income over a long period of time, this risk is less critical. Often a company's downturn is signaled through cuts to the dividend, and if the policy is to sell upon a cut to a dividend, then investors can remove themselves before major damage is done to their portfolio. Many contributors have referred to the famous crash and burn of several large companies like Enron, and how the warning signs were clearly posted for those who were paying attention.
My portfolio is like a game board of Risk. My little army of dollars is off working to create more dollars in dividends, and I have as many more to deploy as I can manage to save in as many turns as I like. Instead of countries, I have squares representing the companies I have invested in. Like a scrappy patchwork quilt, those pieces are not all the same size, yet somehow neatly fit together. I am the sole game-player, but I have all of my advisors, including SA's contributors and commenters standing around my chair, whispering suggestions. The hardest part about this game is that it did not come with a rule book. These we have to painstakingly craft on our own. Mine is still freshly scribbled in pencil with lots of erasings, but I know some here whose worn books are carefully written in ink. This is a wonderful place where I get the chance to stand beside other investors and copy things from their books.
What other risks and risk factors do you see within Dividend-Growth Investing and how are they managed?
Final thoughts from others' playbooks:
Ultimately financial risk resides not in what kind of investments you have but in what kind of investor you are" p. 528 The Intelligent Investor
The Single Best Investment by Lowell Miller:
Only a moderate risk profile will permit investors to attain the cool head and future-vision which is necessary to reach the confidence level that only common sense can bring. Too much or too little risk, and the brain just stops working.