Building A Do-It-Yourself Dividend Portfolio: Critical Rules To Follow (Part 2)

Includes: AGNC, BAC, JNJ, KO, NLY, SO, VZ
by: Parsimony Investment Research

A few weeks ago we completed our 9-part series titled "Building A Do-It-Yourself Dividend Portfolio" in which we highlighted our top-rated dividend stocks within each sector. Our goal was to provide fellow DIY investors with a diversified pool of high-quality dividend stocks that we feel have the potential to be a core holding in your DIY Dividend Portfolio.

While the response to this series was extremely positive (and we thank all readers for their thoughtful feedback), we received many comments and questions asking us to provide additional details about the actual "plan" that governs the DIY Dividend Portfolio. To be completely honest, this was music to our ears. We believe that planning is the most important part of the investing process, yet most investors spend the least amount of time on it (if any time at all).

That said, last week we begin a new 4-part series that will highlight our 4 key principles (in order of importance) to building a successful DIY Dividend Portfolio (see links below for previous articles):

  1. Asset Allocation/Position Sizing (i.e., how much should you buy of each dividend stock?)
  2. Exit Strategy/Risk Management (i.e., when should you exit a stock or hedge your dividend portfolio?)
  3. Stock Selection (i.e., which dividend stocks should you choose for your portfolio?)
  4. Entry Strategy (i.e., when should you buy a specific dividend stock?)

Most investors fail to succeed because they either do not have a plan or they do not have the discipline to stick to their plan. Plain and simple. We passionately believe that if you make these 4 key principles the heart of your investment plan, you WILL achieve long-term success. In addition, we strongly encourage investors to physically write down their rules of investing. This will increase the odds that you will actually follow your rules, which ultimately will increase your odds of success.

Part 2: Exit Strategy/Risk Management

Surely you've heard the adage "Defense Wins Championships". While this cliche is most often used during the halftime pep talk of a high school football game, its certainly relevant in the world of portfolio management as well. However, we like the spin that Warren Sapp (the great defensive lineman) put on this adage a little better..."Defense gives you a chance".

Even though most investors focus more energy on their entry strategy, your exit strategy is really the driver of long-term investment success. Exiting a bad position or hedging your portfolio at the appropriate time gives you a "chance" to win an investing championship (i.e., a happy retirement).

Obviously, picking the right dividend stocks is important too (which we will cover in detail in Part 3 of this series). However, we believe that defensive hedging is what helps you stay in the game over the long term. Income investors need capital to survive and proper risk management strategies will offer excellent downside protection to your DIY Dividend Portfolio when you need it most.

Simple Exit Strategy Rules For The DIY Dividend Portfolio

We believe that investing rules should be as simple as possible. This is the only way to ensure that you will follow them consistently. That said, below are our simple Exit Strategy rules for the DIY Dividend Portfolio:

  • Have the Disciple to Take A Loss When You Need Too - We can't stress this enough. Most investors have a severe case of loss aversion (i.e., they emotionally can't handle taking a loss), so they end riding a loser lower and lower with the hope that the stock will one day turn in their favor. If you are following the right metrics, your dividend stocks will show warning signs months in advance of a real problem. The key is to stay disciplined and to get out of a stock when red flags questions asked (even if it means taking a loss). Trust us, its a whole lot easier to replace income yield than it is to replace capital (especially in retirement).
  • Buy Some Insurance on Your Portfolio - Even though you can't buy portfolio insurance directly from your State Farm agent, you can certainly implement some simple hedging techniques to protect your portfolio and preserve your capital. That said, as you are well aware, insurance is not free. You have to be willing to forego some of your upside to protect your downside, there's no way around it.

"If I can Just Get Back To Break-Even..."

Does this phrase sound familiar? If you ever hear yourself saying this about a stock, you should probably sell it immediately. You're already admitting to yourself (albeit subconsciously) that you want to get out of the stock. So do it!

Stocks can always go lower. In our experience, we have rarely kicked ourselves down the road for taking a loss on an investment. It usually hurts for a few days, but its typically the best decision long-term.

For example, if you owned Bank of America (NYSE:BAC) back in 2008, the writing was certainly on the wall for all to see. Investors had several opportunities to get out of the stock after its initial decent, but many held on with the hope of an eventual recovery (riding the stock down to $2 per share). Unfortunately, the stock is still trading in the single-digits today.

Hindsight is always 20-20, but investors can certainly learn from their past mistakes. When Bank of America first announced that it was cutting its dividend, the stock had already declined almost 50% from its peak. However, disciplined investors had several weeks to sell the stock in the high-$20s before it plummeted into the single digits.

It was situations like this that prompted us to create the Parsimony rating system. We wanted to create a systematic process for monitoring our dividend stock positions. Our composite rating is derived by ranking each stock in our universe based on 28 key fundamental and technical data points. Changes in these 28 data points (and the corresponding change in the Parsimony rating) give us valuable clues about the health of each stock. If the rating for a particular stock declines meaningfully, we will put it on negative watch and decide whether or not we want to sell out of (or hedge) our position.

For example, two of our mortgage REIT positions are currently on negative watch after cutting their dividends in recent quarters: Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC). That said, we will continue to monitor these stocks very closely in the coming months and we will exit or hedge our positions if necessary.

Whether or not you use the Parsimony rating system to monitor your DIY Dividend Portfolio, we encourage you to create and define an exit strategy for yourself and have the discipline to carry it out.

Why Hedge?

Hedging is a tough pill to swallow for most investors because it reduces the overall rate of return on your portfolio when times are good. The tradeoff to that, however, is reduced risk and portfolio volatility when times are bad.

Investors often forget that a significant market correction can wreak havoc on even the highest-quality, dividend-paying stocks. It's actually difficult to find a dividend stock that didn't experience a decline of at least 30% during the 2008 recession. Below are the 2008 maximum drawdowns for some widely held "defensive" dividend stocks:

  • Coca-Cola (NYSE:KO): -40.6%
  • Johnson & Johnson (NYSE:JNJ): -34.4%
  • Southern Company (NYSE:SO): -30.4%
  • Verizon Communications (NYSE:VZ): -42.5%

A proper portfolio hedge could have reduced these losses significantly...without having to sell your stock or give up your dividend!

The Best Hedging Technique

The easiest way to hedge a portfolio is to buy an index or sector ETF put. If you are unfamiliar with options, buying a protective put for your portfolio may seem a little overwhelming. However, rest assured that it is actually a fairly simple technique and it is relatively easy to execute.

The key to executing a successful protective put strategy is to first determine the total exposure that you would like to hedge and then determine how big of a loss are you willing to accept before the hedge kicks in (we typically target 6%-8% on a total return basis). Other important details that you need to consider include determining the length of expiration period as well as the number of put contract to use.

We will highlight a specific example of a protective portfolio hedge in an upcoming article (look for Part 2b of this series).

Note to readers: We will be continuing this very important series over the next few weeks, so please make sure to "follow" us.

Disclosure: I am long NLY, AGNC, KO, SO, VZ.