The Psychology Of Dividend Growth Investing: Defining Success

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Includes: GPC, KO, PG, SPY
by: Dividend Growth Machine

Introduction

Everyone who invests in the stock market wants to be successful. You want to end up with more money than you had when you started, but there are many roads you can take in pursuit of long-term wealth. Some roads will lead to success; others will lead to failure. To know the kind of road on which you are traveling, you need to be able to measure your success along the way. However, before you can measure your success, you need to define what constitutes "success." In this article I discuss two definitions of investing success that have important implications for how individual investors think about and participate in the stock market.

Beating the Market

If you were to survey a wide range of individual investors, financial advisors, institutional investors, hedge fund managers, and the mainstream financial media, I think a common definition of investing success would be "beating the market." That is, having your portfolio achieve a total return that is better than that of a market index such as the S&P 500 (SPY). Beating the market is something that many people aspire to do, but I question whether it is a sensible and psychologically healthy way of defining investing success. Two examples will serve to highlight some problematic issues with this definition.

First, imagine that the S&P 500 index gained 20% in a year but your portfolio's total return was only 10%. You did not beat the market, but does that really count as a failure? Your portfolio is worth more than it was a year ago, the gain outpaced inflation, and you made more money than you would have made by sticking all your money in a savings account. One could reasonably argue that your investing was a success, not a failure.

Second, imagine that the S&P 500 index lost 20% in a year but your portfolio lost only 10%. You beat the market, but does that really count as a success? Your portfolio is worth less than it was a year ago, it has not kept up with inflation, and you could have preserved your capital by sticking all your money in a savings account. One could reasonably argue that your investing was a failure, not a success.

These examples draw attention to the problems of comparing your investing performance with the market's performance. If success is defined as beating the market, then gains will sometimes be considered failures and losses will sometimes be considered successes. I do not think that is a psychologically healthy way to think about investing. Moreover, I suspect it leads some investors to engage in risky and inconsistent behavior, shifting from one strategy to the next or jumping in and out of the market in an attempt to beat it (i.e., market timing). Thus, defining success in relation to the market may not be a good approach for many individual investors.

Growing Dividend Income

One of the few epiphanies I have had as an investor was when I realized that success could be defined independently of the market. How is that possible? The key is to separate your portfolio's total return into its two components: capital gains/losses and dividends.

Capital gains and losses depend on the market's behavior, which you cannot predict and which you have no control over. In contrast, dividends do not depend on the market's behavior. Dividends depend on how a company is doing, not on how its stock is doing. A company will continue paying its dividend as long as its financial condition and business prospects enable it to do so, regardless of whether its stock price goes up or down. For example, there are companies in my portfolio -- Genuine Parts (GPC), Coca-Cola (KO), and Procter & Gamble (PG) -- that have not only paid dividends for decades, but increased them for at least 50 consecutive years. During that half century there were times when the stock of each company fell in price, but their dividends kept growing because each company's operating results supported the growth.

For those reasons, I like to define investing success with respect to dividends. How might it be done? As a dividend growth investor, my primary goal is to create a sustainable, rising stream of dividend income over time. To determine whether I am successfully pursuing that goal, I can compare the dividends received in one time period (e.g., a quarter or a year) with those from the previous corresponding time period.

If my dividend income has increased from quarter to quarter and from year to year (and not simply due to the purchase of additional dividend growth stocks with new capital), then I think it is reasonable to define that as "success." With that definition in mind, I can then measure my success by seeing whether my portfolio's overall rate of dividend growth exceeds the rate of inflation or matches a desired dividend growth rate. Of course, I can also define failure as not achieving growth in dividend income over time, which would prompt changes in my portfolio to re-establish dividend growth.

Focusing on my dividend income stream allows me to define and measure success based on tangible returns that are directly related to my primary investing goal. I do not feel compelled to change my investing strategy based on the market's behavior as long as my dividend income stream continues to grow. Psychologically, I find that I am better able to keep my emotions in check and stay disciplined in my investing, paying more attention to how my companies are doing than to how their stock prices are fluctuating. Benjamin Graham made a similar point in his classic book The Intelligent Investor (1973, p. 205):

Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.

Conclusion

By setting goals and assessing performance in relation to dividends, I am able to define investing success independently of the market and, for that matter, of other people. Thus, I do not concern myself with beating the market or doing better than other investors. This is not to say that I ignore my portfolio's total return; I pay attention to it but I do not obsess over it. What matters more to me is the success I can define and measure in terms of growing dividend income. Of the many roads that may lead to long-term wealth, I am content with traveling on this one.

Disclosure: I am long GPC, KO, PG.

Additional disclosure: My Seeking Alpha username was formerly deedubs. I write under a pseudonym solely for online safety reasons because I have a blog on which I am completely transparent about my portfolio, transactions, dividends, and savings.