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Dear Young Investor,

|Includes: Apple Inc. (AAPL), CMG, SBUX

"Invest risky when you are young" - Yes, in terms of asset allocation NOT security selection. You don't ever want to waste money, especially when you are young and inexperienced.

Dividend growth investing: Lower volatility, Income benefits, higher % of equity in your portfolio, DGI stocks beat the market, tax benefits, low cost, and psychological benefits!

People are unique AND they often do NOT understand their own risk tolerance. This is extremely important when constructing a portfolio.

Dear young investor,

People tell me that they "don't know anything about investing but need to invest"... then they will ask me "what should I buy?" This article attempts to answer that question and explain why I have a strong preference to dividend growth investing over the traditional schools of thought.

So what should I invest it?

That's actually a pretty big question, there are numerous debates, entire college classes, and various books written on the topic. The real answer will depend on YOUR time horizon, risk preferences, liquidity needs, and return assumptions.

First you have to understand that there is a relationship between risk and reward. Stocks historically have higher returns than bonds, but they also have higher risks. Let's say that stocks will return 7% and bonds 3% over time. If you don't need the money for many years, why not invest a higher percentage in stocks and a lower percentage in bonds?

Answer - Liquidity matters and returns aren't linear. What happens if you do put 90% of your money into stocks, the market goes down 50% and you need the money 1 year from now? The math of loss really works against investors, a 50% loss means you need a 100% gain just to get back to 0! Remember stocks have a higher expected reward potential, but also more risk of losing value.

Traditional Asset Allocation investing advice

A very basic rule of thumb is to take your age, subtract 100, and use that number as your equity percentage. If you are 35 years old, that would mean a mix of 65% stocks, 35% bonds. That's a very basic rule of thumb and YOU have your own unique situation with your own unique answer.

Some companies will have you fill out questions - then they put you in a "box" and recommend a certain asset allocation. Hi John, based on your answers you fall into our "balanced growth" box, you should invest like this blah blah blah.

I believe that people are unique. It's NOT a science, it's a blend of science and art. What if there are twins, with the exact same financial situation but one is an "ant" and one is a "grasshopper"? What if one panics and sells at a loss, and one sticks things through? What if somebody half @** fills out their questionnaire?

The crazy thing is that people don't accurately understand their own risk tolerance. Where people THINK they are and where they REALLY are can vary greatly. It's easy to pump your chest and say risk risk risk when the market is rising but when the market goes down some of the same people end up cursing the "rigged" market.

Dividend Growth Investing and its advantages

I'm very favorable to a Dividend growth investing - or buying stocks that have a solid history of paying and increasing dividends each and every year for the following reasons:

1) Lower Volatility - It seems like common sense but this article referenced by Keith French from the Chicago Booth School of business shows that over 86 years, when stock market goes down, dividend stocks don't go down as much.

2) Income benefits - There is nothing worse than buying a stock at say $100 per share, it rises to $140 per share, and then goes back down to $100. You held it and have nothing to show for it, I am biased to owning stocks that pay ME the OWNER a share of the PROFITS. Historically, maybe 75 or so years ago, people used to look at stocks more of the way they look at bonds today or the way DGI investors look at stocks.

3) Higher % equity - * see below

4) Dividend growth stocks outperform other stocks - Seng Hong Teoh performed his own study showing that a basket of 10 carefully selected DGI stocks outperformed the general market - not only did they have higher returns, but they had lower volatility.

Jeff Paul shows a study of U.K. dividend stocks outperforming non dividend payers.

The Heartland fund advisors article referenced above links a study showing that from 1802 - 2002 that dividends plus growth in dividends accounted for 5.8% of Equities 7.9% total annualized return.

Due to survivorship bias, and actually which DGI stocks are selected - saying DGI stocks outperform the market can be hard to prove in my opinion. This is why your basket of dividend growth stocks should be chosen carefully. You want the best of the best. A value stock buyer in real estate terms wants to buy the fixer upper in the great neighborhood and flip it. A dividend growth investor wants to buy the best house in the best neighborhood and be a landlord. The DGI investor is generally OK with paying market value for the house even though they ideally want to buy at a discount.

5) Tax benefits - A DGI portfolio can be placed into a Roth IRA and be collecting growing dividends for decades. Dividends that aren't taxed.

6) Low cost - You could end up paying hundreds of thousands of dollars worth of fees to mutual funds over your investment lifetime. Just think, if that mutual fund fee is 1%, that's 1% every year, whether the S&P 500 is up 10% or down 20% - you are still paying that 1% (and some funds charge more). Unscientifically I'd argue that most dividend growth investors manage their stock portfolio fee free. It keeps you in control/active and you might even find it fun!

7) Psychology benefits - This is difficult to quantify but should not be understated. There is a reason why the average investor has lower returns than the market. Everybody knows to "buy low and sell high" but few do. Mike Tyson famously said that, "Everybody has a plan until they get punched in the face". Most people end up buying high and selling low because they are trying to time the market, the financial news media scared them, or forced selling due to liquidity needs.

As a dividend growth investor I don't have to sit at my computer with my itchy finger hovered over the sell button when the market goes down. I feel more like a stock/company owner than a fast money trader. It actually gives me great pleasure to know that "I" own a piece of the world around me - ownership in some of the best companies in America.

* Higher % of equity - People say that when you are younger you should invest "riskier". I do agree with that statement, but over time I've changed how I interpret it. When I heard this advice as a young investor I was told to buy "riskier" stocks.

If I were advising a young person I'd argue that you should invest riskier younger - but in terms of asset allocation - BUT YOU STILL WANT THE BEST QUALITY STOCKS!!! Instead of maybe going 80/20 stocks to bonds you want to go maybe 95/5 for the reasons highlighted above. With a quality DGI portfolio you will have presumably lower risk, higher returns, and income built in. Over time you will have a powerful DGI machine at your service, growing and compounding at an amazing rate - and you don't have to worry about selling or timing the market.

If you want to take a small portion of your portfolio to try and buy the next Apple (NASDAQ:AAPL), Starbucks (NASDAQ:SBUX) or Chipotle (NYSE:CMG). Fine - go for it! But the Lions share of your portfolio - especially while you are young and learning the ropes should be invested in Dividend Growth Investments.

So which dividend growth stocks should you buy?

An excellent starting place is the David Fish CCC list. I'd also suggest reading like minded investors on these pages of Seeking Alpha to manage your own Dividend Growth portfolio.

Time preference. We don't have unlimited time... Many of my dividend growth stocks I've owned for nearly 10 years. I trust them. I don't have to worry about fluctuations in earnings and "crashes". I can spend my time researching big alpha generating ideas.

Good Luck.


Disclosure: I am/we are long AAPL.

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.