Dividend investing is more popular than ever and as I’ve said, I am convinced that dividend investing is much more than a trend because in the end it leads many investors to becoming rich.. It is an investing philosophy that is likely to do well over long periods of time. Sure, it will under perform in certain circumstances but I think most agree that we are not likely to see huge bull markets anytime soon. Much more likely are flat to down markets are the deleveraging continues and while Europe continues to deal with its main issues.

Dividend investors will tend to do much better in such markets. That being said, I think that dividend investors still need to build an optimal portfolio to manage risk as efficiently as possible. Why?

Not Optimizing Your Portfolio = Leaving Money On The Table

Basically, a portfolio that does not manage risk correctly might do better for a few weeks or even a few months but over longer periods of time, a portfolio that has good risk management will perform better, have less volatility and is less likely to have serious problems.

How Can I Manage Risk In My Dividend Portfolio?

There are a few different things that should be done when managing a dividend portfolio:

-Diversify the industries that you buy: Owning a stock that is heavy in financials, commodities or any other type of industry is not optimal. You ideally have a few names in each industry in order to do well no matter how the economy does.

-International Diversification: Holding a few international names or US stocks that have strong international business will help you from suffering big losses if one economy such as the US one suffers from big problems. This also gives you protection from dollar weakness and provides you with significant opportunities in foreign markets.

-Monitor Your Holdings: At all times, you should monitor your holdings by doing the following:

-look for signs of weakness in sales and/or earnings
-look for any slowing down/halts/reductions in dividend payment increases
-keep stop losses that will limit the losses you can suffer on one stock. Big declines also often signal upcoming dividend reductions.

Ideally, you get rid of your weaker stocks early on in order to keep a strong looking portfolio.

How Often Should This Be Done?

I personally feel like all names should be looked at on a monthly basis (at a minimum) while things like having solid diversification and international exposure can be looked at on a quarterly basis.

How Do You Manage Risk In Your Dividend Portfolio?

I rarely discuss bonds here which could be seen as surprising since it is a huge market, one that every investor ends up buying in. The explosion of ETF’s has also made it much easier and affordable to invest in as well. it has even made it possible to create fully diversified retirement ETF portfolios.

As many of you know I believe in the bucket approach to investing, I’ve discussed it more in the mailing list but basically, dividend investing and a diversified ETF portfolio are my most important investments. The ETF portfolio as you would expect includes bonds.

A few weeks ago, I had money to reinvest and noticed that I was under invested in bonds. I hesitated. Should I? Shouldn’t I?

Everyone Says Bonds Have Peaked

At their most basic, bonds have two components to their returns:

-coupons
-price variations

The big problem these days is that few expect bond prices to increase. Why? Because as a general rule, the biggest influence on bond prices are interest rates. As those increase, bond prices diminish. The opposite is also true of course. So you could say that all things being equal buying bonds is a good thing when rates are likely to decline.

Now take a look at current interest rates level. Tell me, how much further can rates go? Rates are basically at 0 except for very long term rates. The odds that one or two years from now, rates will be lower or even at the same level are basically 0%. So yes, on the surface, buying bonds these days seems like a losing proposition.

Go Back 12 Months

Of course, 12 months ago, most experts said basically the same thing. Rates were near 0, the outlook was dark but still, few expected rates to remain at those levels. Forward to today and those that bought long term bonds ended up doing great. In fact, it turned out to be on of the best investments in 2011. Why? Continued economic issues, Europe, etc.

Could 2012 Be Exactly The Same?

I guess it’s more than possible that bonds, even long term bonds will continue to do well this year. Why? Depressed economy and struggling governments remain central themes and it’s very likely that interest rates will remain depressed for a very long time. Could they go even lower? Certainly it’s possible. I would say that it’s unlikely that they could go much lower so if prices of those bonds do go up, it will not be as much.

Still… I Am Buying Bonds

In the end, the whole principle behind a passive ETF long term portfolio is to stick to certain asset allocations and avoid trying to time the market. It’s difficult to accomplish, especially in times like these where it seems obvious that I should overweight or underweight certain asset classes. In the end though, I firmly believe that over long periods of time, it is much safer to stay away from such temptations. You could say I don’t live up to this blog’s name (Intelligent Speculator) but I would argue that some investment accounts should be more aggressive and others shouldn’t. I buy bonds in the long term/retirement accounts.

What about you, are you buying bonds? Do you think it’s a bad time to buy more? I’d love to get your thoughts

I’m sure you’ve heard such things before:

“Look for companies that you know and do business, look at how well they are doing and then make stock purchases on that basis”

It’s Insane To Think In Such A Simple Manner

Investing is NOT easy, it really isn’t. If you are looking for a clear method to make good stock picks, then dividend investing might be the right thing for you. Again, you would not be judging the company based on how many friends you know that shop at the local store or how good of a service you get every time you visit. I’m not saying that it’s irrelevant… ok maybe I am.

If All You Needed Is To Find Companies That You Liked, Life Would Be Easier

Take two companies that I’ve been praising over and over, Amazon (AMZN) and LinkedIn (LNKD), not only do I know both companies well but:

-I use them on a weekly basis
-So do most of my friends and family
-We would pretty much all have great things to say about our experiences working with AMZN and LNKD
-I love their business not only from the consumer point of view but also from the investors perspective. Why? These companies will end up making tons of revenues and profits in the coming years and totally dominate their markets
-I would love nothing more than to call myself a shareholder of these names

But I’m Not Pulling The Trigger because…

Everything Has A Price…..

In my opinion, investing is all about valuations. Dividend investing takes a slightly different perspective but even that incorporates valuations to a large degree. Buying stocks based on how well the business seems to be doing is insane.

Take Amazon. The company does TONS of business, sells products more than almost any other retailer, at very low prices. It is also spending millions reinvesting into its business through shipping centers, new digital products, etc. All of those will end up paying, I’m 100% convinced about that. But is Amazon a big bargain at its 100+ P/E ratio? Honestly, I’m not even sure it’s a decent price, it probably isn’t. At some point, Amazon will be able to diminish its investment level which will help margins a great deal. That could take some time though.

As for LinkedIn, I think the company has incredible upside, it will most certainly take the place of companies such as MonsterWorldwide (MWW) in the near to medium term future. That being said, it’s P/E ratio for next year is over 100….

They Both Have Upside

I would be fearful of shorting either of these companies. I was asked on yesterday if I regretted not being short Amazon (AMZN) going into its earnings (stock ended up tanking after very disappointing results and outlook). My answer? “Not at all”. I could not short Amazon or LinkedIn. They both could easily explode and turn out to be great investments or terrible shorts.. I like to think I’ve learned my lesson.

Caution Ahead

So why not buy a stock that could explode? Because it’s all about probabilities. In both of these cases, I think that while the stock could explode, there is an even bigger possibility that LNKD and AMZN will end up going down. They are valued for such strong growth that anything short of “exceptional” will mean losses for those shareholders. Exceptional might happen and I hope it does for those 2… but I’m not putting money behind it.

Can you relate any way? Have you heard some friends or family that bought stocks for reasons that had nothing to do with valuations?

Last week, I discussed dividend investing mainly to argue those that say dividend stocks are a bubble and that dividend investing was just a trend that would eventually fade away are dead wrong. My conclusion was that dividend investing will only grow bigger and more important. In my opinion, that is a good thing. It will encourage companies to be more disciplined with their cash which should be good both for the markets and for the general economy. Company executives generally have a lot of interest in how well their company’s stock performs and that is becoming even more true these days as companies increasingly switch to deferred compensation made through stock and options.

What I Mean

In the past, executives would get a large amount of cash paid every year

Now, these execs get some cash and a lot of interests in the company (shares and options) that will be worth a lot if the stock performs well.

Growing number of investors looking for dividend stocks will help companies that are willing to commit to such payments. Since the execs want the stock to do well, creating, paying and increasing their company’s dividend is a great way to increase their overall compensation.

Dividend Investors Will Tend To Become Much Richer Than Others

I strongly believe that dividend investors will tend to be much better off over their lifetime for a few different reasons:

-Better Investing Discipline: Dividend investors have very clear ways to select stocks and determine if they can be kept. That generally helps them be less emotional and more rational about those picks which is a great thing in the end. Also, having a clear model is an important aspect of being a successful investor

-Controlled Spending: Ask anyone about getting that brand new tv and few would say they’re not interested. Dividend investors though have a clear view of the downside of such a purchase. Basically, every expense can be looked at from the point of view of a dividend stock. $2000 might get you a nice tv, but it could also mean an annual cash flow of $60 that increases every year for your entire life. This does not mean avoiding to spend but it does mean considering the future lost revenue when spending. And yes, that generally ends up meaning less spending.

-Clear Objectives: In most cases, dividend investors are trying to gradually replace the income that they live off by dividend income. That process does not happen overnight but with steady investments and good picks, it does eventually become a possibility. Dividend investors tend to have a rather clear image of where they need to get and far away those objectives are. Why? Because as time goes by, the amount of dividends received every month will evolve and become closer to whatever money you feel is required to live off of. Contrast that to the typical investor that has no idea how much money he will need, how to get there, etc.

In the end:

Dividend Investing = Investing Discipline + Diminished Spending + Clear Objectives
Dividend Investing = $$$$

It’s a bit annoying honestly. Why in the world do so many people in the media and elsewhere like to punch on dividend investing and those that use it. I’m not saying that it’s a perfect investing method or even the best one around, but saying that it’s just a fade or a big bubble is at least as ridiculous. I’m not sure if those writing such stories do so just because it will make a good story, to get a good story out there or if they truly believe it. Here are the top reasons why I think that dividend investing is not only there to stay but will actually become much bigger over time:

DIY (Do It Yourself) Investors

A few decades ago, the only people investing in the markets were professionals. Sure, you had the exception here and there that was buying and selling stocks but for the most part, individuals that had money had a broker that would try to get the best returns possible. That has changed in recent years. Why? Because of the exaggerated fees that were being charged, because an increasing amount of information has been made available to the public through the internet

Add to that the appearance of discount brokers that have made it cheap and easy for individuals to buy stocks, making what would have been very difficult a few years ago, a growing trend.

Dividend Investing Is An Amazing Long Term Investing Method

What is the reason most players end up losing big when they go to a casino? Sure, the odds are stacked against players but there’s also the fact that very few people enter a casino with rules regarding how they will play, how much they are putting into play, etc. It takes discipline for investors to be successful. For most of us, that means haviing a clear, easy to follow  set of rules that can be followed.

How in the world can most of us tell what Exxon (XOM) might be worth or if we should be buying gold, oil, Euros, etc. The investment world is incredibly complex and I think there is something to be said for having a simple but reliable system to make investments.

A Stock’s Value = ?????

The basics of finance are that the value of a stock is:

Stock value = Present value of all future cash flows

In almost all cases, dividends are the only type of cash flows that shareholders do receive so I think that it makes a lot of sense to invest from that perspective. One counter-argument would be that doing so will end up excluding many high growth stocks like Apple (AAPL). Fair enough. But if you use that argument, there is no end really. You could probably add real estate, futures, commodities, currencies, alternative assets, foreign companies, etc. There is no end. So I don’t think there’ s anything bad with using a smaller universe (dividend stocks) to find our investments.

It Provides A Clear And Easy To Follow Methodology

Unless you are a professional (and even those might struggle), you’ll have a hard time telling me what any given stock is worth. However, if I ask you a different type of question, the common investor might be able to do exactly that:

-How much will this stock pay you back and how likely will that amount increase (and by how much) over time?

The 2nd answer is not easy by any means, but it’s certainly much easier to get my head around it.

Psychology Change

I’ve also discussed the importance of seeing a dividend portfolio as what it should be, an increasing amount of cash flows. Sure, we’d all like the “value” of the portfolio to increase, but in the end, that is not what it’s about. It’s about making enough money to pay for your retirement when that time comes. I’ve also discussed how I believe a dividend portfolio is much better alternative to annuities. From that perspective, trying to buy dividend stocks makes a lot more sense to me than trying to find undervalued growth stocks.

I would love to hear your thoughts on this, do you think dividend investing will end up being just a trend? If not, why?

You might think it’s obvious right? I mean you buy and sell a stock then depending on the return, you can calculate a return. For example:

I buy 100 shares of Microsoft at $26.11 and sell them for $28.25. What is the return?

100 x (28.25-26.11) = $214 profit

Return = Profit / Invested Amount = $214/$2611 = 8.20%

I got an interesting question from a reader that is replicating some of the trades being done here regarding how returns are being calculated.

For long and short trades, that is different. To make my case, I will explain using my 1st trade of the year where I went long Apple (AAPL)and short Blue Nile (NILE). If I am managing a portfolio worth $35,000, and investing 1/7 of that amount in each trade (as per my 2012 trading changes), then I basically have $5000 in each trade.

So on January 5th, I bought Apple (AAPL) and sold Blue Nile (NILE). Keep in mind that there is “no cost” (excluding commissions) to entering into this trade. What do I mean? With $5000, I will be able to

Buy for $7150 worth of Apple (AAPL)
Sell for $7150 worth of Blue Nile (NILE)

That will leave me with the same amount in my account ($5000), an amount that I need to keep as “collateral” for my position. With this amount I am able to:

Buy 17 shares of Apple @ 410.00
Sell 175 shares of Blue Nile @ 40.69

Then, a week or so later, I closed the trade:

Sold 17 shares of Apple @ 419.70
Bought 175 shares of Blue Nile @ 35.47

The profit is:

Apple $165
Blue Nile $914
Total $1079

So on the $5000 that I was using to open this trade, I made a return of 21.6%. As you can see in the “Stock Picks” page, that is how I’ve been calculating returns. The other way would be to calculate the return as follows:

Return = Profit / Bough and Sold amount

In my opinion, that would not be representative however since for a total of $35,000 in the account, I would be buying for $50,000 of shares and selling the same amount.