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Illustrative Comment To "Asset Allocation For A Dividend Growth Investor" By David Van Knapp (10 Feb. 2012)

David Van Knapp wrote excellent article "Asset Allocation For A Dividend Growth Investor" (seekingalpha.com/article/349011-asset-al...

I'd like to comment using the graphs below. I'm a dividend investor and now all my money are in stocks. I always ask myself "Am I right?" and the mentioned article forces to ask once again.

Let me start from my thoughts about asset allocation. David Van Knapp considered stocks, bonds and cash and pointed that bonds are not needed for dividend growth investor who has steady but not sufficient income (pension and SS). The "ground zero" asset class - cash should be always available for emergency, etc. and comments to the article show no doubt in it and I agree. So 2 asset classes are left. David Van Knapp argued that for a Dividend Growth Investor (NYSE:DGI) bonds are not needed.

Stocks and bonds are not only possible assets classes. Nowadays, financial advisers propose now long list of so-called "alternative investment" classes on the top of bonds and stocks. They also recommend rebalance between them on regular basis.
I think this is quite dangerous for investor because
a) nobody deeply understand several assets classes (even with ETFs) an investor just plays Russian roulette if (s)he puts money on the table without proper knowledge;
b) the main purpose of rebalance (hidden market timing) is to generate cash for financial advisers.

As far as I understand assets allocation approach tryes to minimize fluctuations of prices. Theoretically any 2 classes with anti-correlated prices should fit an assets allocation model if investor need to take "cream" (well, RMD, for example, see note 1 below) from investment on regular basis.
If an investor goal to have income stream (seems most important during retirement) the investor might not worry about prices of dividend growth stocks but should worry about inflation. In contrast to standard assets allocation approach income stream and inflation should be strongly correlated.

But is dividend growth rate (DGR) in synx with inflation? The only really long term study I aware of shows that they are not (see figure from "Value Investing: Tools and Techniques for Intelligent Investment" book by James Montier).

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As far as I understand this graph represent ALL stocks in US, probably trend is different a set of companies which pay rising dividends but there is no insurance that some such companies reduce or omit dividends.

If we look on S&P500 stocks only (data from American Association of Individual Investors - Download Library, Historical Market Data) for last few decades we can see that after about 1966 stocks yield in average was smaller than inflaton while bonds provided better than inflation return:

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As you can see long-term bonds in last 25 years provided inflation insurance. Now in 2012 bond yield is so low that such insurance disappears,

The following figures show DGR (trailing 12 months) versus inflation graphs for large- middle- and small-caps S&P stocks I created from from American Association of Individual Investors - Download Library, Historical Market Data.

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The pictures above show that it is hard for a stock-income investor to handle inflation during a market depression when many companies cut their dividends. Again sets of large- middle- and small-caps S&P stocks and dividend growth stocks are not the same although some stocks are in both sets.

I also plotted 3- and 10- years averages (figure below) by readers request. It seems that DGI works for a decade timeframe but a protection (2nd asset class?) is needed for an investor with smaller patience.

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I choose 3 years because I hold cash for 3 years in case of any emergency (e.g. unemployment which is still high in California) and 10 yers per your email. 10-years picture for 1956-mid 2011 is in favor of DGI while 3-years isn't. I guess 5 or 7 years will be good for DGI but I don't think it make sense to have cash for more than 3 years of regular expenses. So again probably 2nd assets class is needed for middle term type of disaster.

I think a pure DGI should have broad diversification between stocks in different capitalization categories with high yield and relatively small DGR and stocks with DGR well above average inflation in all cap categories.
Another practical conclusion from the last graph is not to spend and re-invest all dividends from DG stocks in good years and safe some money for rainy days.

Probably 2nd asset class (not necessary bonds) is needed for DGI during high inflation. Should it be gold or something more exotic for inflation? I don't know... That I know is the facts that inflation in some countries was well above 100% and even 1000% (to compare with ~ 20% worst in USA recent history) and as far as I remember from book "Triumph of the optimists: 101 years of global investment returns" by Elroy Dimson, Paul Marsh, Mike Staunton the government bonds of these countries were worthless in hyperinflation periods. Fed. monetrary policy in last few years makes hyperinflation possible in USA, esp. if China and other countries switch off US debt and US dollars.

The situation for pure DGI is even worse during deflation. Companies cannot increase price of their products and probably demand is also drops. So during deflation earnings and therefore dividends should decrease. Again probably 2nd asset class (bonds?) is needed for DGI during long deflation. I'm not aware about behavior of diferent assets during deflation - might be Japanese experience is helpful but I have no clue what is/was going there.

Note 1: Required Minimum Distribution (NYSE:RMD) calculator /pointed in a comment to the article/ requires about 4% withdraw at age 70 and 8% withdraw at age 90. I think that DG stocks portfolio with good initial yield (e.g. 3% for 62 y.o. investor) and reasonable DGR can provide enought "cream" (dividends) in order not to touch capital.