Today's post concludes our Lessons from 2013, picking up with dividends.
Lesson 10: The Road to Riches Isn't Paved With Dividends
Over the last few years we've seen a dramatic increase in interest in dividend paying stocks. The heightened interest has been fueled by both the media hype and the current regime of interest rates that are well below historical averages. The low yields available on safe bonds led even many once conservative investors to shift their allocations from safe bonds to dividend paying stocks. This is especially true for those who take an income, or cash flow, approach to investing - as opposed to a total return approach, which I believe is the right approach.
How did that strategy play out in 2013? The 418 dividend paying stocks within the index (equal weighting them) returned 40.7 percent. The 82 stocks that didn't pay dividends returned an average of 46.3 percent, outperforming by 5.6 percent.
Admittedly, these results are for a very short period. So we'll take a look at some long-term data from a study by the research team at Dimensional Fund Advisors (DFA). As you review the results keep in mind that classic economic theory says dividend policy should be irrelevant to stock returns.
DFA's March 2013 study, "Global Dividend-Paying Stocks: A Recent History," studied the data from 23 developed markets over the period 1991-2012. The following is a summary of their findings:
- The simple average annual returns were 9.1 percent for dividend payers and 11.1 percent for nonpayers. However, the standard deviation of the returns of nonpayers was higher than for dividend payers. The net result was that the annualized returns were the same - 7.6 percent for both dividend payers and nonpayers. However, by focusing on only dividend payers, an investor would exclude about 40 percent of firms, thereby sacrificing diversification benefits.
- Although less volatile than the capital gain component of stock returns, the aggregate stream of dividend payments is subject to the same broad, macroeconomic risks that affect capital gains. For example, in 2009, 14 percent of firms around the world eliminated their dividend, and 43 percent of firms reduced their dividend. In other words, dividends can provide an illusion of safety.
The evidence demonstrates that investing in dividend paying stocks is just another example of the "conventional wisdom" on investing being wrong - there doesn't appear to be any advantages to a strategy of investing in dividend-paying stocks.
Lesson 11: Don't Allow Scary Headlines, or Stage-One Thinking, to Lead to Abandoning Your Investment Plan
In 2013, investors were subject to a fair share of headlines highlighting significant defaults on the municipal bonds of such cities as Detroit, Stockton and San Bernardino. For many investors these defaults brought back memories of the December 19, 2010, forecast by Meredith Whitney. Appearing on 60 Minutes she forecasted that a tidal wide of defaults would occur in the municipal bond market in 2011: "You could see 50 sizeable defaults. 50 to 100 sizeable defaults. More. This will amount to hundreds of billions of dollars' worth of defaults."
In light of those scary headlines, which led many investors to flee or avoid the municipal bond market, let's review the performance of municipal bonds since Whitney's infamous forecast and compare them to the returns of Treasury bonds.
We begin by comparing the returns of the Vanguard Intermediate-Term Tax-Exempt Fund (VWITX) with an average duration of 5.4 years with the returns of the Vanguard Intermediate-Term Treasury Fund (VFITX) with an average duration of 5.2 years. Keep in mind that the returns are total returns and are pretax returns. Data is from Morningstar.
2011 Return (%)
2012 Return (%)
Overcoming the headline defaults, the total return of VWITX since 2011 was 14.0 percent, outperforming VFITX's total return of 9.6 percent by 4.4 percent. And this is even before considering the impact of taxes.
We now compare the returns of the Vanguard Limited-Term Tax-Exempt Fund (VMLTX) with an average duration of 2.4 years with the returns of the Vanguard Short-Term Treasury Fund (VFISX) with an average duration of 2.2 years.
2011 Return (%)
2012 Return (%)
2013 Return (%)
We see similar results here with VMLTX providing a total return of 6.1 percent, outperforming VFISX's total return of 2.9 percent by 3.2 percent. Again, this is before considering the impact of taxes.
While there have been some significant defaults, the massive scale of problems Whitney anticipated didn't occur because governments have taken action to address the problem such as cutting spending and raising revenues. As a result, there was a dramatic decrease in the budget gaps.
The closing of budget gaps, and the reluctance of the public to approve new debt issuance, meant that new bond issuance shrunk dramatically. Reduced supply is a positive for investors. Additionally, the sharp drop in rates allowed many municipalities to refinance higher rate debt, further closing budget gaps. The net effect was that the level of issuance in 2013 wasn't sufficient to offset the calls and maturities, leaving the market with net negative new issuance.
Further good news for muni investors was received when U.S. Bankruptcy Court Judge Steven W. Rhodes accepted Detroit's petition enabling it to seek protection under Chapter 9 of the U.S. bankruptcy code, and ruled Detroit may legally reduce public pension benefits, despite protection of public pensions under Michigan's constitution. Rhodes' ruling has positive implications for municipal bond holders across the country.
There are two important lessons for you to take from this tale. The first is to remember Warren Buffett's admonishment to ignore all forecasts because they tell you nothing about where the market is going. The second is to avoid the mistake Ms. Whitney made of engaging in stage-one thinking. Ms. Whitney, along with many investors, saw a crisis developing in municipal budgets, and the risks, but failed to see beyond that. On the other hand, those that engage in stage-two thinking know that while there's no certainty, they do expect that a crisis will lead governments (and central bankers) to come up with solutions to address the problem. And the worse the crisis gets, the more likely they are to act with urgency and scale. That insight allows them to see beyond the crisis (enabling them to keep control over their stomach and their emotions).
Lesson 12: Don't Let Your Political Views Influence Your Investment Decisions
One of my important roles as a director of research is preventing investors from committing what I refer to as "committing portfolio suicide" - panicked selling that results from fears. In 2013, it seemed that the majority of the times I was called in to help investors stay disciplined, the fears were generated by politics. For example, those on the left feared that the Tea Party would derail the budget and debt negotiations leading to the Treasury defaulting on our debt. Those on the right expressed views that our capitalist economy was being driven off the tracks by a "progressive" agenda. Of course, each person I spoke with was convinced that the problems would derail the economy and the market.
We often make mistakes because we are unaware that our decisions are being influenced by our beliefs and biases. The first step to eliminating, or at least minimizing, mistakes is to become aware of how our decisions are impacted by our views and how those views can influence outcomes. The study, "Political Climate, Optimism, and Investment Decisions," showed that people's optimism towards both the financial markets and the economy is dynamically influenced by their political affiliation and the existing political climate. Among the author's findings were:
- Individuals become more optimistic and perceive the markets to be less risky and more undervalued when their own party is in power. This leads them to take on more risk. They overweight stocks with higher systematic risk and exhibit a stronger preference for high market beta, small-cap, and value stocks. They also trade less frequently. That's a good thing as the evidence demonstrates that the more individuals trade, the worse they tend to do.
- When the opposite party is in power, their perceived uncertainty levels increase and investors exhibit stronger behavioral biases, leading to poor investment decisions.
While there were plenty of anxious moments, those that remained disciplined were rewarded and those that panicked and sold not only missed the bull market, but now face the incredibly difficult task of figuring out when it will be once again safe to invest. Unfortunately, there's never a green flag that will tell you when that's the case. Thus, the strategy most likely to allow you to achieve your goals is to have a plan that anticipates that there will be problems, and don't take more risk than you have the ability, willingness and need to take - and don't pay attention to the news if doing so will cause your political beliefs to influence your investment decisions.
2014 will surely provide investors with more lessons, many of which will be remedial courses. And the market will provide you with opportunities to make investment mistakes. You can avoid making mistakes by knowing your financial history and having a well-thought-out plan. And reading Investment Mistakes Even Smart Investors Make will provide you with the wisdom needed to avoid making them.
Before closing there's one more important point to cover. The well above expected returns earned over the past two years provides an opportunity for you to review your investment plan in order to determine if the bull market has altered one of the key assumptions of your plan. Specifically, if you have already accumulated significant wealth, or are in the withdrawal phase of your investment career, such strong returns reduce the rate of return you need to earn in the future in order to achieve your financial goals. Thus, they lower your need to take risk. If that is the case, you should consider taking some of "your chips off the table" by lowering your equity allocation.