Investing for dividends is like driving half a car …

half car 2Like this guy, you could probably drive in half a car (at least, if you were smart enough to first select the best half  i.e. the bit with the engine) …

… but why would you want to?

You could take your supplements purely for the extra vitamins, and you may even gain all extra the nutrition that you need …

… but, why wouldn’t you want to take one that has all the trace minerals that you need, as well?

You could probably invest in real-estate solely for the rental income …

… but, why wouldn’t you want to get some capital appreciation, as well?

If you feel the same way as me, why should investing in stocks be any different?!

That’s what I have to ask James @ Dinks Finance who says:

Dude, dividend stocks are not substandard investments. They may not yield as much as directly investing in your own business, but they can and do produce very respectable returns for many people.

Well, dude, you probably wouldn’t choose to regularly drive half a car; you probably wouldn’t choose to take half a supplement; so, why would you choose half an investment?

And, make no mistake: selecting an investment purely on the basis of its dividends is choosing half an investment.

Why?

Well, Matt Kranz of USA Today says:

The total return [of any stock] is a tally of the net gain, or loss, an investor received by owning a stock and receiving the dividend. When you add the change in value of the stock to the dividend, you calculate the investors’ total return.

To calculate total returns on a stock, Matt says:

Start by adding the value of the dividends to the stock price at the end of the period. Subtract from that sum the price of the stock at the start of the period and divide that difference by the price of the stock at the start of the period. Multiply by 100 to get the percentage.

Here’s an example. Say a stock started the year at $20 a share, paid $2 a share in dividends and ended the year at $25 a share. The total return would be:

(27 – 20) / 20 or 35% total return

Dividend investors usually then counter with an anecdote of great personal returns, like this one from Tim:

I don’t know what sort of return you require but I have invested in a number of dividend producing stocks over more than 20 years and at least for my purposes the returns have hardly been sub-standard. Investments in MO, PM and MCD to mention several have provided very nice returns over the years.

But, Tim, if you follow my advice and look for stocks on the basis of their Total Returns rather than just Dividends, then you still may have invested in MO, PM and MCD, but you would also have invested in both AAPL (Apple) and BRK (Warren Buffett’s Berkshire Hathaway).

Westwood (a registered investment advisor) explains why chasing high dividends is not always the best strategy:

Generally, the highest yielding stocks are there because investors question (by forcing the price lower and, thus, the yield higher) the long term prospects of the business, and/or whether the payout can continue.

Current day examples include Avon Products, with its high 5.0% yield.

While Avon may be a well-known business, the company carries a lot of debt, and many speculate the dividend will need to be cut to manage this large debt load.

Or, consider the 8.5% yield of Pitney Bowes.

While the absolute yield is attractive, the level of EPS (earnings per share) is flat with 1999 and the stock is at a 20-year low. Again, investors question the long term health of the postage meter market, and Pitney Bowes’ ability to fund its dividend going forward.

So, people who look specifically at stocks that produce dividends are looking at only half the story …

… that’s why I say that investing for dividends is, almost by definition, a sub-standard investment selection methodology:

You may happen to come across the best stocks in the country, but – if you invest in the best returning stocks, regardless of what combination of dividends and/or capital appreciation produces those returns – then you are sure to!

The Myth Of Passive Income

I see a lot of people chasing the dream of passive income.

Like unicorns, the Tooth Fairy, and – sadly – Santa Claus, truly passive income does NOT exist!

The only true ‘set & forget’ passive income comes from sub-standard investments such as bonds, CD’s, mutual funds, dividend stocks, and the like.

All true income-producing investments require at least some work in selecting/maintaining the income source

e.g. Rental real-estate requires work to locate the best deals, then requires further work to locate and retain the best tenants, and requires even more work to maintain the property.

Of course, some of this can be outsourced to Realtors and property managers, but you cannot outsource your worry (e.g. if the property lies vacant and your mortgage payment falls due).

Even more, a business can never truly be passive: you will always have to worry about staff, clients, and finances.

Even if you hire staff to manage all of these areas for you, you will still have to oversee – and, worry about – them!

In my experience, the higher the return you expect, the less passive is your investment.

Why I don’t have a wealth manager …

madoffThere’s a debate going on at Quora (the question and answer site) about the cost of wealth managers:

What are the pros and cons of wealth managers vs passively investing in an index fund?

One of the issues is comparative fees:

– Index Funds typically charge 0.07% of funds under management.

– Wealth Managers typically charge 1.00% of assets under management.

So what do you get for the 14 times increase in fee?

Well, I wouldn’t know, because I wouldn’t go near a “wealth manager” with a barge pole …

… but, Scott Burns said it best:

40 years of investing has taught me that rented brains seldom help us build our nest eggs. Rented brains feel a deep spiritual need to build 20,000-square-foot log cabins in Jackson Hole with the return on our money.

It would be OK if that 14 times extra fee equated to extra returns, but the research shows that it really does only buy the wealth manager a good living – not us:

Eugene F. Fama and Kenneth R. French looked into this issue in their working paper titled, Luck versus Skill in the Cross Section of Mutual Fund Returns. Their study focused on U.S. equity mutual fund managers from 1984 to 2006. It’s no surprise that they found that in aggregate, actively-managed U.S. equity mutual funds performed below the market after costs. The big question they were trying answer was did the winning managers have skill or were they just lucky?

So, if you are prepared to read a few books and try a few things, then go ahead and try your own luck in the stock market … failing that, simply put your money into a low-cost index fund – a least, you’ll avoid the heavy management fees!

Transitioning to retirement …

withdrawal1You’re hard at work, trying to to reach Your Number, and you’ve cranked up your Perpetual Money Machine to make sure that you get there …

… now, there’s not much to do except work the plan.

So, let’s fast-forward a few years and think about what happens when you finally reach Your Number.

If you recall, you calculated your Number simply by:

Taking your Required Annual Living Expenses (which you adjusted for inflation) x 20.

Now, where did this Rule of 20 come from?

It is simply the same as withdrawing 5% from your Number each year.

Picture your Number as a pile of cash that you made by saving, investing, or even selling your real-estate and/or business portfolio, and now it is sitting safely in the bank as cash or CD’s, earning bank interest each year. The question is, how much can you safely withdraw each year to live off (like paying yourself a wage) so that you never run out of money?

When you are busy ‘working’ (be that on a job, in a business, or on your actively-managed investment portfolio) you will dream of nothing but having that pile of cash that equals Your Number just sitting there.

But, when you have that pile – hopefully, very large pile – of cash you will suddenly realize:

1. You have to pay taxes on the interest,

2. You have to beat inflation,

3. You have to spend some of your capital to live,

4. You have to survive market downturns.

You have to hope this money lasts as long as you do!

… all of a sudden, you have to be VERY protective of Your Number.

When you are working, you fear losing your job. When you start to invest, you fear losing some or all of your investments. When you start or buy a business, you fear closing down. The reality is that you can recover from any/all of these scenarios given a little extra time and work. But, if you lose Your Number, you have lost everything … and, the longer it takes to lose it, the less time/chance you have of recovering it.

So, a key question becomes: what is a SAFE percentage of Your Number to withdraw each year? Usually, a great place to start is by looking at what ‘the experts’ recommend …

Unfortunately, there is support out there for just about any annual % of Your Number (i.e. your retirement nest egg) that you may choose to spend, for example:

7% – Not so long ago, the financial services industry proposed spending as much as 7% of your portfolio each year in retirement.

6% – More recently, Paul Graangard wrote two books proposing a combined bond-laddering and stocks strategy that, he suggested, supported a spending rate as high as 6.6% of your portfolio each year.

5% – Investment funds routinely allow spending of 5% of the portion of their investment portfolios dedicated to simply keeping up with inflation. Indeed, my Rule of 20 appears to support this withdrawal rate, too.

4% – A large number of studies – probably, the most famous of which is the so-called Trinity Study – advocate spending up to 4% of your initial portfolio (ideally, 50% stocks and 50% bonds, rebalanced each year), which provides somewhere between a 90% and 100% certainty that your money will last at least 35 years.

3% –  A whole slew of new retirement planning tools (generally using a Monte Carlo approach to modelling tens, hundreds, or even thousands of potential economic scenarios) have been released over the last 4 or 5 years by the financial services industry, purporting to analyse hundreds of alternative economic scenarios to try and model what would happen to your retirement portfolio (i.e. simulating changes in interest rates, market booms and busts, etc.) to find the ideal ’safe’ withdrawal rate. A lot of these advocate very low withdrawal rates, typically in the 2.5% – 3.5% range.

2% – Some even advocate a totally ‘risk-free’ approach to retirement savings by investing close to 100% of your retirement portfolio in inflation-protected bonds (e.g. US Government Inflation-Protected Bonds – TIPS; Municipal Inflation-Protected Bonds – iMUNIs); historically, these have provided less than 2% return, after inflation but with total protection of your starting capital.

So, which is right?

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