Recently, Christine Benz of Morningstar published, "The Error-Proof Portfolio: How Do Your Financial Priorities Stack Up With Our Pyramid?" In the article, she presented an investing pyramid to suggest how to allocate your investing time and resources.
At the bottom of the pyramid are the activities that you should spend the most time and energy on because they have the biggest impact on your results….Meanwhile, at the top are tasks that, though worthwhile, will have a smaller impact on your bottom line….It can also assist in keeping more experienced investors on the right track. After all, the more you know, the more likely you are to geek out about small matters such as whether to own a high-yield exchange-traded fund or an actively managed fund. In so doing, it's possible you'll lose sight of game-changers such as your saving and spending rates and your total asset allocation.
In the pyramid, top priorities appear at the base of the pyramid, while at the top are the least important ones. Here is Benz' pyramid.
As with most articles that Morningstar produces, this pyramid is quite MPT-oriented (referring to Modern Portfolio Theory). It is commonly taught by MPT adherents that more than 90% of your returns are explained by asset allocation. That's why asset allocation is given such an important place in the pyramid. A corollary is that once you have your asset allocation set, the choice of individual investments is relatively unimportant. That's why investment selection is given little emphasis.
As a dividend growth investor, I see some things similarly to Ms. Benz but other things quite differently. This is my modest suggestion for a Pyramid of Success for the Dividend Growth Investor. Again, the most important things are toward the bottom, forming the foundation for items above.
Let's work from the most important up.
1. Know Thyself
Behavior in investing is perhaps the most important element. Behavior stems from each individual's beliefs, values, skills, knowledge, and emotions. So I place knowing oneself in the most important location at the very base of the pyramid. Ultimately everything you do as an investor depends on who you are. It influences everything above it.
As we age, no one stays the same. Life happens, including events such as graduation, marriage, divorce, childbirth, and retirement. We learn, and we change. So "know thyself" is not a one-time accomplishment. It is a lifelong process.
On this subject as it relates to investing, one of my all-time favorite quotes is from Warren Buffett, who himself quotes Thomas Watson, the founder of IBM (NYSE:IBM):
There's a whole bunch of things I don't know a thing about. I just stay away from those. I stay within what I call my circle of competence. Tom Watson said it best. He said, 'I'm no genius, but I'm smart in spots, and I stay around those spots.
As an investor, I try to stay around the spots where I believe that I have some competence.
2. Set Goals and Objectives
Those who have seen my articles about planning (such as this one) know that I am a strong advocate of strategic thinking. The top level of planning is setting your goals. I agree with Benz that this is a foundational step. Here's what she said:
Rather than operating with the amorphous goal of "wealth accumulation," take a step back and articulate the specifics of what you're trying to achieve, when you'll need the money, and how much. Paying the full freight for college for each of your kids? Retirement while you're still young enough to enjoy it? A move to a bigger house within the next five years? By quantifying each of your financial goals, you may see that it's not going to be possible to achieve them all, but it's better to know that early on so you can prioritize. And each of those goals likely carries its own time horizon, which in turn will dictate what types of investments you hold and where.
Here is the goal that I have set for my wife's and my two dividend growth portfolios, one of which is public and can be seen here. This goal is based on our desire to have a reliable stream of inflation-beating income in retirement.
The goal of the Dividend Growth Portfolio is to generate a steadily increasing stream of dividends paid by excellent, low-risk companies. The numerical target is for the portfolio to
deliver 10 percent yield on cost within 10 years of inception. I am more interested in the ability of this portfolio to produce income than its sheer size.
The underlying principle about setting goals, of course, is this: If you don't know where you want to go, how can you figure out how to get there?
3. Develop Plans and Strategies
Once you have clear objectives, you can set to figuring out how to achieve them. It can be fuzzy sometimes as to what is a strategy and what is a tactic, but ultimately you need both. Strategies are general plans, while tactics are more specific guidelines and rules that you intend to follow to make your plan a success and ultimately to achieve your goals.
This layer in my pyramid is roughly analogous to the "Asset Allocation" portion of Morningstar's pyramid. Since they follow MPT, their strategies are mostly predetermined, because they generally believe that "proper" asset allocation is the answer to most investment questions.
What I am suggesting instead is that the investor seriously think about investment principles, and relate those back to their goals in order to select the best ones that will help meet those goals. Sometimes an MPT-type solution will be just the ticket, but other times it will not be the best choice. It ultimately depends on who you are and what you are trying to accomplish. One size does definitely not fit all. The strategies and tactics for achieving a total-wealth goal are significantly different from those best suited to an income goal.
My own plans and strategies appear in a document that I call my "constitution." It is the set of rules and guidelines that I have established over the years. I update them annually or whenever I realize there is a hole or a situation not covered. My constitution represents the distillation of my best thinking, performed when I am not emotionally involved. It evolves as I learn more, either from study or from confronting new situations.
I depend on my constitution to keep me pointed in the right direction when I am faced with ambiguous or fast-moving situations. I want my decisions to be guided by my best thinking, not the emotions of the moment.
4. Save Enough
There's no way around this. No matter what your goals, strategies, and tactics are, you need to have money to invest. There is a lot of advice available about saving, living below your means, etc. Here's what Benz said in her article:
Budgeting is boring, which is why it's easy to give short shrift to it in favor of sexier pursuits such as trading stocks. But even if you select the very best investments, you'll be hard-pressed to make up for a shortfall if you haven't saved enough. That's why setting your saving and spending rate has far more importance in the pyramid than does investment selection. As a result of technological advances and new electronic budgeting tools, there have never been more ways to monitor and manage your spending. This is key to ensure that your savings rate puts you on track to achieve the above-mentioned goals.
The budgeting concept applies not only to the accumulation stage of life, but also to planning for retirement (how much will you need?) and retirement itself (how do you match your resources to your expenses?).
In retirement, another way to think about income is as expense coverage: How much income will you or do you need to cover not only necessities but also the things you want in retirement? Those expenses will probably go up while you are retired. How will inflation impact you? How will you account for inflation?
5. Pick Investments
This is where I depart most markedly from Morningstar's pyramid. They designate investment selection as the least important thing. I think it is a lot more important.
Even before I began studying finance and personal investment, I had heard of the concept that asset allocation trumps investment selection. I now understood where the principle comes from: According to MPT, over 90% of investment returns can be explained by asset allocation. If you set up your investments to match the "best" asset allocation, so the thinking goes, it does not matter much what the individual investments actually are.
I suppose that if one's goal is the accumulation of the most wealth, and if one confines oneself to index-type products, the claims about asset allocation make more sense. But as a dividend growth investor interested in optimizing a growing income stream over many years, the asset allocation model falls short. Investment selection - stock picking - takes on much more importance.
Among all the thousands of stocks, only a relative handful - around 500 - are sensible to even consider. David Fish's Dividend Champions document contains most of them. Stock selection - based on sensible analysis and valuation - is at the heart of dividend growth investing. It is not the least important thing. It is one of the most important things you do after you have figured out your goals and how best to achieve them.
I follow a two-step approach in stock selection: Company Quality and Stock Valuation. I have written extensively on both subjects, as have many others. The basic idea is to identify stocks with the yields and growth characteristics that you want, then try to buy them opportunistically at the best valuations you can find. You always keep your eye on the income goal(s) that you are trying to accomplish.
Once you have started to invest, you are a business manager. You are the CIO (Chief Investment Officer) and CEO (Chief Executive Officer) of your own investing operation. I believe that most of the best investors treat investing just like a business.
If you google "what do managers do?," you get over 1.8 million responses. Typically, you will find scholarly papers and popular articles. Many have themes like, "Eight things that the best managers do."
I was at a seminar once, and the leader asked that same question. The class came up with many answers, and soon a huge list of all the tasks that managers do was on the board. But where the leader was going was this: In the end, managers do two things: Make decisions and execute those decisions. All the myriad tasks and activities can be classified into those two categories.
At the top of every SA page you see this:
The last two words in the slogan are "decide" and "invest." In other words, make decisions and execute those decisions.
At the portfolio level, managing means continual research and monitoring your portfolio. It could also mean amending portfolio weightings, adding new stocks, deleting stocks, etc. My view is that individual self-directed investors are "active investors" in the sense that they are always making decisions, even if the decision is to do nothing.
Making decisions actively does not necessarily lead to lots of trading. In my public Dividend Growth Portfolio, there have been only six transactions all year, and two of them were simply to reinvest dividends. For example, an important decision that has not led to any activity yet is to hold but closely monitor Intel (NASDAQ:INTC) after they failed to increase their dividend when I expected them to. I have developed a game plan for Intel, and I am executing it right now, in the sense that I am monitoring the situation, and I know what I will do if certain things happen (or don't happen) by certain dates.
You also need to manage yourself. It is very common nowadays to read about behavioral finance, the ways in which investors sabotage themselves through bias, emotional thinking, and the like.
Usually, emotions come into play because someone is paying close attention and reacting to the stock market. Daily or weekly price swings can have a powerful impact. The common theme is fear: Fear of losing money as prices slide downward. Fear of giving up in just a few weeks or days the gains that it took several years to achieve. Fear of paying too much.
Many studies show that selling at inopportune times is part of what causes many investors to underperform the very investments that they own. For me, the antidotes to market fear are patience and focusing on the income from my investments rather than their capital value. Seeing things from a longer perspective usually helps. This may be especially hard for young (restless) or old (retired) investors: Both groups may believe or feel that they must see results now. My suggestion would be to try to re-frame that feeling. Perhaps there is another point of view that would relieve the pressure and still be believable to you.
Just because an investor may have unhelpful tendencies and influences does not mean that they have to be victimized by them. They can be managed. Manage thyself.
The top of the pyramid represents those times when you will want or need to change what you are doing. As noted earlier, we all change as things happen to us, we gain experience, market conditions change, and so on. No one needs to be rigid in their investing approach nor in their thinking.
Your annual constitutional review is a great time to take a step back and think about whether you want to make any adjustments in your investing approach.
Disclosure: I am long INTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.