Thermodynamics Of Investing And The DGI Mindset

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Includes: DGRO, DGRW, DIVC, JTD, LEAD, NOBL, PFM, RDVY, REGL, SDY, VIG
by: Ted Fischer

Summary

The Laws of Thermodynamics paint a stark view of the physical universe. These challenges are mirrored in investing.

You cannot win the game unless you find a way to challenge these principles.

The DGI mindset changes the rules, helping unsophisticated individuals meet their long-term goals.

Allen Ginsberg famously paraphrased the three laws of thermodynamics with the quip:

  1. You can't win.
  2. You can't break even.
  3. You can't get out of the game.

In reply to which, Harris Freeman is quoted as saying:

Every major philosophy that attempts to make life seem meaningful is based on the negation of one part of Ginsberg's Theorem.

Capitalism is based on the assumption that you can win. Socialism is based on the assumption that you can break even. Mysticism is based on the assumption that you can quit the game.

While investing is not exactly rocket science, there are certainly some parallels for the retail investor! Not only does each of Ginsberg's lines apply to the investor experience, Freeman's commentary suggests three possible answers to embracing this defeat.

You Can't Win

You have surely encountered references to the annual Quantitative Analysis of Investor Behavior, both in financial articles and in marketing literature. Dalbar serves financial advisors, so it is unsurprising that their statistics come to the conclusion that the average investor needs help (others have questioned the methodology used). For example, the 2014 study suggests that the average mutual fund investor experienced a 20-year annualized return of just 2.6%, well below the 7.4% return on the S&P500 or the 4.6% return on bonds. If we accept these results, the retail investor over the last 20 years has generated returns that barely pace inflation!

Half a century ago, Fred Schwed asked, "Where Are the Customers' Yachts?" Despite everything that has changed in the financial markets, you could ask that same question today and receive a similar answer. The financial industry vigorously resists the "fiduciary standard", offering advice that, "costs Americans 1 percentage point of their return annually." It doesn't take an astrophysicist to realize that the system is rigged to profit the professionals.

You Can't Break Even

Last year we were regaled with results from a Fidelity internal review that concluded, "The customer account audit revealed that the best investors were either dead or inactive." While this particular story may be apocryphal, the results ring true. Every trade costs investors on both the commission and spread, and inexperienced investors exhibit a strong "recency bias" that induces them to buy high and sell low. Fund investments are subject to steady friction, as Wall Street takes its cut at every turn, and the maddening volatility of the markets can easily be imagined as a form of entropy. It is easy to see the inexorable hand of the Second Law at play as your investment portfolio slows to a halt.

You Can't Get Out of the Game

Unfortunately, despite the dismal implications of the first two laws for our investments, we cannot afford to quit. Fidelity suggests that we should typically aim to have accumulated 10x our annual income by retirement (though I strongly recommend seeking professional assistance or using a retirement calculator as individual situations vary greatly). Even under the most favorable assumptions - risk-free returns approximating inflation and a steady income throughout 40 years of employment - an individual hoping to save for retirement without exposure to the equity or bond markets would need to save 25% of all income to hit this target. The average savings rate in 2014 was just 4.4% (and the most frugal demographic was only 13%), so this is clearly not a workable approach for most people. Even if the game is rigged against you, you still have to play.

Are we doomed, then? You can't win. You can't break even. You can't quit the game! Yet before we succumb to nihilistic despair, consider Freeman's commentary and how each might suggest a solution to our dilemma.

Can you win?

Professional money managers push this meme. Hedge funds justify their 2/20 by claiming to deliver above-average risk adjusted returns. Sell-side analysts peddle their newsletters, promising market insights and hot tips to beat the market. And in fact some actively managed mutual funds, such as Fidelity's Contrafund (MUTF:FCNTX), have shown above-average returns over impressively long time frames.

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Unfortunately, there is little evidence that any manager can achieve market-beating returns consistently. As the summary table below shows, Fidelity Contrafund has trailed the market averages over the last five years. It would seem that the ten-year outperformance resulted from successfully navigating the 2007-2008 crash, with little or no value added since. If Will Danoff with decades of experience and immense resources cannot beat the market consistently, how can an individual investor hope to compete?

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Can you break even?

Once investors give up on trying to beat the market, convinced by the statistics to accept Efficient Market Theory as a working hypothesis, they often shift their investments to index funds. Index funds don't actually match the market, of course, but (for example) the 0.16% expense ratio for the Vanguard 500 Index Fund (MUTF:VFINX) is low enough that it doesn't hurt much. On a million-dollar portfolio (for our investor seeking to accumulate 10x their annual income), that amounts to just $1,600 per year. Broad-market index funds also tend to be tax-efficient, since they trade infrequently. You can think of an index fund as analogous to waxing your skis, greatly reducing the friction of your investing even if it is impossible to eliminate it entirely. Jack Bogle's advice is sound.

Unfortunately, the greater threat to investment returns is investor behavior. Even an index fund investor may be tempted to bail out of equities in a market crash, buying into bonds or gold at the worst possible time in search of security. Thus investors are often encouraged to work through financial advisors, adding layers of fees on top of the modest fund expenses. While a good advisor can be effective in correcting behavioral errors, this costly arrangement is more likely to pay for the advisor's yacht than the client's.

Can you quit the game?

While some investors may be lucky enough to end up with a money manager who helps them beat the market by a sufficient margin to pay the advisory fees, and others may have the equable temperament to follow an index strategy on their own, Dividend Growth Investing offers a third alternative. You can "quit the game" by adopting a different mindset in your investing, one which Chowder details powerfully in this article. In his words:

Most investors ask, "What's my account's current value?" A dividend growth investor asks, "How much dividend income did my portfolio generate?"

Most investors ask, "How much was my account up or down this year? A dividend growth investor asks, "How much did my account's income grow this year?"

Most investors ask, "Where is the stock market going this year?" Dividend growth investors don't try to predict short-term swings in the market.

I was reminded of this stark difference in the mindset by an exchange in the comments thread of a recent article.

Placebo Investment Advice:

How many people have provided audited evidence that they've beaten the market in the long enough to offer a credible expectation of future outperformance?

Chowder's Response:

I don't know and respectfully opine that I don't care.

What is important to me are the portfolios I manage. I also don't care what the performance of the market is. When I'm helping someone set up a portfolio, the first thing I do is ask them what is it exactly they are trying to accomplish. If they tell me their goal is to beat the market, I don't waste my time. They can't tell me what the market is going to do going forward, and if you don't have a clue on what the target is, how in the world do you expect to hit it?

I establish well defined goals and then buy companies or funds that will support those goals. I believe people looking for growth and those for capital preservation require different strategies. Something such as growth and income vs income and growth strategies have subtle differences that could make all the difference in one's results.

Yet despite these differences, they agree on a very fundamental point.

Placebo Investment Advice:

Perhaps your suggestion that people need to learn to control emotions is a bigger problem than some might realize?

Chowder's Response:

Yes it is. The emotions of fear and greed do more to destroy portfolio value than being a lousy stock picker. The better one learns to manage their emotions, the better they will manage their portfolio, and to do that people need a system they follow and then make adjustments as they go along. When the system is consistent on an ongoing basis, you learn from mistakes and successes, and do more of one and less of the other.

The bitterness towards fund managers and advisors is that far too many of them push their own goals and objectives as opposed to meeting individual needs. They apply too many cookie cutter strategies. They tell us what we should do instead of showing us how to do what it is we want to do.

We know that the stock market is volatile. We have to find a way to accept and live with that volatility, since we can't hope to beat it and can't afford to avoid it. Key to that is the dividend growth investing mindset. Consider this chart of the S&P share price and composite earnings:

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In contrast, dividends are quite stable. Even in the financial crisis, dividends fell just 25% from their peak and rebounded quickly. This was in an environment where the S&P500 fell 50% and earnings disappeared entirely for a year! An investor who is focused on their dividend income stream is better prepared to weather a bear market than one who is concerned primarily with price appreciation.

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Moreover, it is well understood which industries are most sensitive to economic conditions. An investor focusing on the "defensive" sectors of Consumer Staples, Healthcare, and Utilities would likely not have seen even a single dividend cut in 2009. The cuts that year were concentrated in the cyclical Financial sector, just as the more recent dividend cuts have mostly stemmed from the cyclical Energy sector. While there is never a guarantee of a smoothly increasing dividend stream, an investor who works to hold quality companies in defensive sectors can come much closer to that ideal than one who is taking a different approach to the market.

In his article, Chowder writes:

Common sense dictates that the only hope for long-term success is having the ability to stick with the plan.

Common sense in investing means employing a strategy that is actually linked to the companies in which you've invested. Investing is about being a partial owner of a real business.

Common sense means spreading out your risks, but not so much that you lose control over your portfolio.

Commonsense investing is about establishing a comfort level that allows you to stay calm while others around you are in the state of panic or deep concern.

That is a very different mindset than the financial industry would have you follow. It doesn't rely on expensive professional advisors. It doesn't emphasize a quarter-by-quarter focus on price, earnings, and volatile valuation ratios in the hope that they will eventually even out. It seeks out the stability of high quality companies with predictable income streams, paying steady and well-covered dividends.

You can't win. You can't break even. But you CAN change the game.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.