This is Part 4 of a 5-part series that highlights each step of our recommended investment plan that will help you build and monitor your own DIY Dividend Portfolio.
The Importance of a Proper Investment Plan
Most "do-it-yourself" investors fail miserably over the long term. As a matter of fact, the majority of professional investors fail to beat the returns of the broader market indices every year. That said, there is one common trait that every successful investor shares…an investment plan!
Unfortunately, simply setting up an investment plan isn't enough to succeed these days. You also have to have the discipline to carry out that plan (come rain or shine). Contrary to popular belief, the market does not control your investment success…you do!
While the specific details of a dividend investor's personal investment plan will vary based on age, risk tolerance, etc., we suggest that investors use the plan below as a guide (links to previous parts of this series are highlighted below in blue):
- Identify, research, and invest in dividend stocks with the best risk/reward profiles.
- Identify low-risk entry points for each stock (i.e., a "Buy Zone").
- Adhere to strict asset allocation targets (for asset classes, industries, and individual stocks).
- Maintain a disciplined exit strategy for each stock by closely monitoring changes in fundamental and technical data points.
- Utilize portfolio hedging techniques and conservative option strategies to manage downside risk.
Part 4: Exit Strategy
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 raising cash (i.e., selling winners) at the appropriate time are risk management strategies that you can't afford to ignore.
Obviously, picking the right dividend stocks is important too (which we covered in detail in Part 1 of this series). However, we believe that your exit strategy (along with defensive hedging, which we will discuss in part 5) 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.
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:
Establish Maximum Loss Thresholds
We all make bad investment decisions from time-to-time, its part of the game. Knowing that, you should never let a few losses destroy your entire portfolio. Establishing a maximum loss threshold for individual stock positions is a great way to mitigate this risk. Depending on the size of your portfolio, we believe that the 0.50%-1.00% of total portfolio value is a good maximum loss threshold range to target.
For example, if you have a $100,000 dividend portfolio with a 0.50% maximum loss threshold, you should limit your loss on any one position to $500 ($100,000 x 0.50%). So if you bought 50 shares of McDonald's Corp (NYSE:MCD) at $88.00, you should limit your loss to $10 per share ($500 / 50 shares). This rule should also keep you disciplined with your position sizing!
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 up 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 appear...no 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).
Chimera Investment Corp. (NYSE:CIM) is a perfect case study as to why this rule is so important. Despite its juicy dividend yield, most long-term Chimera shareholders are probably still trying to get back to break-even. If these CIM investors would have taken a loss early on, they could have reinvested that capital into a handful of other mortgage REITs, like American Capital Agency (NASDAQ:AGNC) or Annaly Capital (NYSE:NLY), which have significantly outperformed CIM over the past few years on a total return basis. DIY Investors should always consider the opportunity costs of holding onto a loser.
It was situations like this that prompted us to create our 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 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. Using our rating methodology as a guide, DIY investors could easily set up their own process for monitoring the health of their dividend stocks. The key is to keep your methodology simple and to diligently monitor your stocks (at least on a quarterly basis). This is the heart of "portfolio management"!
Play With The House's Money When You Can
It's important to take profits when you can, especially if you feel that the market is due for a pullback. One strategy that we like to use when taking profits on a big winner is to sell part of our position to get all or most of our initial investment out. This strategy will help you free up some cash while allowing your "winner" to run further.
For example, if you bought Bank of America (NYSE:BAC) at $4.50, you could sell half of your position now (at $9.40) and pocket your entire initial investment. This will give you some cash to reinvest on a pullback, but it will also allow you to profit from BAC if the stock continues to run.
Note to readers: We will be continuing this very important series over the next few days, so please make sure to "follow" us.
Disclosure: I am long AGNC, NLY. 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.