The Most Challenging Aspect Of Dividend Investing

Includes: AGNC, FDO, NLY, WMT
by: Dividend Growth Investor

Many dividend investors focus exclusively on finding the best dividend stocks. They spend countless hours analyzing companies, studying balance sheets, and perfecting their entry criteria. Yet, when the companies appreciate in price, investors decide to cash in and move on to the next idea. This happens despite the fact that it took investors a lot of time to identify and research the opportunity. Unfortunately, investors might end up worse off with the new investment idea, in comparison to just sitting tight and doing nothing.

I am always fascinated that investors who are quick to pull the trigger on gains they generate freeze to death when their stocks cut or eliminate distributions. They become hopeful, when they should be fearful of losing their nest eggs. These investors end up hoping and praying that one day their dividend income will break even, meaning that they will generate as much income as when they originally made on the investment.

These examples appear to be black and white, and too rigid. If investing has taught me anything, it is that things always change and that one has to remain flexible in their investment approach. Yet, one recurring pattern in my investment portfolio that I have noticed is that winners tend to keep winning, and losers tend to keep on losing. In the world of dividend investing I have found that companies like the constituents of the dividend achievers list have a very high probability of continuing their streak of consistent dividend increases. I have also found that companies which cut or eliminate distributions are seldom good investments for the long term investor, even if they eventually decide to regain their dividend growth stock status.

What I am attempting to describe here is the fact that dividend investing is very difficult. It is not difficult because of complexity of analyzing balance sheets, moats and business models. It is difficult because a large component of the investment equation deals with investor psychology. Even if investors are shrewd enough to have selected the best dividend stocks in the world at the right price, they could still end up not making any money, or even worse - losing money.

Investors who purchased at the right price can do no wrong by simply holding onto the rising income stream, as long as the distribution is not cut or eliminated. The dividend trend should be their friend. Unfortunately, psychologically speaking, it is very difficult to hold onto a winning position. A position that goes up 50%, 100%, 200% and even more over a period ranging from a few months to a few years or even decades would make most investors want to ring the cash register. This would be the case even if the underlying fundamentals are still intact, and the bullish trend in earnings and dividend payments is expected to continue into the future.

For example, back in 2008, it was possible to purchase shares of retailer Family Dollar (NYSE:FDO) at $20/share, while it was paying $0.50/share every year. The yield of 2.50% was the highest in several years and the P/E of 12 made the stock look attractive. Over the next four years, the stock has managed to more than triple in value. During the same time earnings have almost doubled, while dividends have increased by 70%. The dividend yield decreased to 2% in 2009 and has been mostly below 1.50% since 2010. Many dividend investors tend to sell after a run up, particularly if current yields drop to low levels. These investors then purchase another stock in the sector, that might appear like a better value and might offer a better yield. Since 2010, Wal-Mart (NYSE:WMT) has provided a much higher yield in comparison to Family Dollar. Investors who sold Family Dollar after 100% gains in 2010 however, have missed out on gains of over 70% over the past two years. While an equivalent investment in Wal-Mart in 2010 would have generated at least a 50% gain, investors would have had to pay capital gains taxes on their gain on the sale of FDO stock.

Another psychological problem that dividend investing poses is that it is a slow process of building wealth and passive income. For many, it would take anywhere from one decade to several decades, before they reach their crossover point. Few investors have the tenacity to forgo current consumption and stick to a single investment strategy for years. People tend to give up easily when confronted with certain tasks where the payout is a long time away. It is very difficult to compare your long-term approach of dividend investing to the get-rich-quick mentality of most other investors, who might have made quick gains in volatile technology stocks over the past year. Investors who decide to take shortcuts to achieve their target dividend income might end up being disappointed in the process. Some shortcuts include taking excessive leverage that could lead to huge investment losses even during a small market correction, or using options and futures without a complete understanding of their risks. Another shortcut could include loading up on high-yielding companies such as mortgage REITs like American Capital Agency (NASDAQ:AGNC) or Annaly Capital (NYSE:NLY). If short term interest rates start increasing faster than longer term interest rates, the distributions that these mortgage REITs pay would be in big jeopardy.

The psychological dilemma of successful dividend investing is evident for situations where investors have purchased companies that have raised dividends for a certain number of years, and where they keep raising them in the future. Many investors have been taught at school or at their jobs that inactivity does not result in payoff. As a result, many end up selling winners, paying capital gains taxes on the proceeds and limiting their upside this way. Unfortunately, successful dividend investing is sometimes counterintuitive to this way of thinking, since it is all about being right and maximizing this to the fullest extent possible, even if it takes several decades of positive reinforcement.

Disclosure: I am long FDO, WMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.