When “Buy What You Know” Makes Sense

Last week, My Own Advisor wrote an interesting post about whether investors should buy companies they’re familiar with. He was responding to a recent article by Larry Swedroe, which argued that “Buy what you know” is a bad strategy. Swedroe himself even joined the spirited debate in the comments section.

As I read the post and the comments, it struck me that the two sides were arguing two very different points. In the interest of being a peacemaker, I’d like to frame this debate differently and find some common ground.

Why pick stocks?

Let’s start at the beginning by asking why investors pick individual stocks in the first place. Back in the days of Graham and Dodd, investors had little choice but to analyze and buy individual companies, since there was no way to “buy the market.” That hasn’t been true for a long time, of course. Today, buying the market is easier and less expensive than ever. With equal amounts of the Vanguard Total Stock Market ETF (VTI) and the Vanguard Total International Stock ETF (VXUS), for example, any investor can own 9,742 stocks in over 40 countries for an annual cost of 0.13%.

So if it’s cheap and easy to buy the whole market, why buy individual stocks? There are many specific answers, but I think all of them fall into one of two categories.

The first reason to pick individual stocks is that you believe you can outperform the market. This means either obtaining higher after-tax returns, or the same returns with lower volatility.

The second reason is less obvious, but it’s just as important. As Meir Statman has long argued, investing isn’t just about earning the highest possible returns. It also has expressive and emotional benefits. For example, you might choose socially responsible investing because it’s a way of expressing your values. Or you might simply find stock picking enjoyable, even exciting. You still want to earn healthy returns, of course, but lagging a benchmark may not be that important as long as you meet your financial goals.

When it comes to “buying what you know,” there is clearly an emotional benefit: familiar companies, especially those that pay reliable dividends, make investors feel safer. Indeed, judging by the comments on MOA’s blog and my own, this is far more important than beating the market. Some examples:

“I have slowly converted into a dividend investor, not necessarily because I think dividend stocks will outperform, but rather because I think quality dividend stocks offer a safer investment for me.”

“I will sleep easier at night holding a few big companies [rather] than all of the market… I will have a regular dividend stream of income, probably some decent capital appreciation, and a smoother ride.”

“My focus is not on earning higher returns than the market. The major attraction of a dividend strategy is the dividend itself.”

“I have more faith buying companies I know and understand, that have decent fundamentals and pay dividends, than a basket of stocks [where] I don’t have a clue what a third of the companies are.”

“For me, dividend investing is more predictable, with a return I am happy with.”

“To me it’s all about getting dividend checks in the mail, on a monthly basis.”

“Dividend-paying companies are not necessarily superior, rather they provide me with assurance about their long-term prospects.”

Finding common ground

So here’s the problem with this debate. When Swedroe writes that “buying what you know is a bad strategy,” he’s considering only the first factor. His argument is that if your goal is to earn market-beating returns, then buying familiar companies is a poor way to do that. And he’s correct—as I have argued in a previous post.

But the comments above make it clear that many dividend investors are not really interested in market-beating returns. They don’t particularly care which strategy is optimal when you run a thousand Monte Carlo simulations on a computer. They’re arguing that by “buying what they know” they will be more likely to stay invested during difficult times. And they’re right, too.

Their thought process goes something like this: “If I held index funds I’m afraid I would sell them if the markets tanked. But I take comfort from owning a basket of profitable, dividend-paying companies that I know will bounce back eventually. And for that reason, I’m more confident about staying the course.” It is hard to argue with that.

Yes, the data are clear that passive investing, when executed properly, is the optimal strategy for individual investors. But if you have no confidence in the strategy, you will never execute it properly. And if you abandon it at the wrong time, you’re guaranteed to fail. Confidently holding a portfolio of familiar stocks may be not be a market-beating strategy, but it is surely superior to being a jittery passive investor who will sell in a panic.

On that point, I think we can all agree.

43 Responses to When “Buy What You Know” Makes Sense

  1. Alan M March 19, 2012 at 7:26 am #

    That all makes good sense, and why I like ETFs like XDV, CPD, XPF and CDZ in my portfolio. Steady income, chance for steady if slow gains, and for sure, sound slumbers!

  2. Alcharesta March 19, 2012 at 8:53 am #

    What a refreshing and informative blog full of well researched facts and very well touhgt opinions. In particular, your view on this debate is a perfect example of how you can present things so it is hard to argue against you. Keep on the good work!

  3. Michael James March 19, 2012 at 8:54 am #

    The way you say it sounds so much nicer than “go ahead and make the small mistake of buying dividend stocks because if you tried to do the right thing you’d just make even bigger mistakes.”

  4. Canadian Couch Potato March 19, 2012 at 9:09 am #

    @Michael: I hope I don’t sound patronizing. I just think we all need to admit that no investor executes their strategy perfectly, and we always have to take into account the cost of our mistakes. I’ve had a lot of people tell me, for example, that the ING Streetwise Funds are too expensive and I shouldn’t recommend them when you can build an ETF portfolio for half the cost. My answer is, no, you can build an ETF portfolio for half the cost. Not everyone can.

    Real estate is another example. Personally, I would never buy an income property because I think the long-term expected returns of stocks are higher (and a lot less work). But that’s because I’m comfortable investing in stocks and I know nothing about being a landlord. A handyman who knows nothing about stocks but can capably and confidently manage an income property would probably do much better with real estate.

  5. Brian March 19, 2012 at 10:21 am #

    I think that you are right in that it comes down to each individual investors definition of ‘success’. Some will pay a premium (whether it is higher expenses or ‘non-optimal’ returns) for either simplicity or feeling comfortable while others will lament them for being stupid/irrational for needing comfort. Bottom line is that it is their money, and if they have a big pile of it, they are probably doing something right.

  6. Canadian Couch Potato March 19, 2012 at 10:33 am #

    @Brian: Thanks for the comment. Let me be the first one to say that a desire for comfort is never stupid or irrational. I hear this kind of thing a lot when people criticize conservative investors for using GICs, etc. Hating volatility is not irrational, and dampening a portfolio’s volatility, even if leads to lower returns, is entirely reasonable if it allows you to sleep easier.

  7. Larry Swedroe March 19, 2012 at 10:44 am #

    What you are arguing is that investors get behavioral benefits from some strategies. I won’t disagree. But for example you can get expressive benefits from investing in hedge funds, you are member of an exclusive club and it shows “status” and “sophistication.”
    Unfortunately that has proven to be a bad idea for most investors as hedge funds have in aggregate produced very poor returns.

    Similarly you can be a SRI investor and do so in a passive way and without buying individual stocks and taking the uncompensated risks.

    And is it not better to be educated on the negatives and understand your behavioral errors than to keep making the same mistakes? That is why I wrote Investment Mistakes Even Smart People Make and How to Avoid Them.

    The biggest issue with buying what you know is that investors confuse information with VALUE RELEVANT information. Almost certainly what investors know about some company is already known by the market and thus incorporated into prices. And we know the evidence is very clear that the majority of investors playing the active game lose to Mr. Market, enriching only Wall Street.

    I used to buy individual stocks for the same reasons others do. I learned better and stopped. And the good news is the winning/prudent strategy is much simpler–you don’t even have to know anything about individual companies or spend time researching them and following them. Just let Mr. Market do the work for you.

    Best wishes
    Larry Swedroe

  8. Canadian Couch Potato March 19, 2012 at 10:58 am #

    @Larry: Thanks so much for stopping by and adding a comment. I agree completely that the best thing we can do as investors is to try to understand our behavioral mistakes through education, and your books (as well those of Meir Statman, Gary Belsky and Tom Gilovich) have been a huge help in this respect.

    http://canadiancouchpotato.com/2012/01/16/why-we-love-the-one-were-with/
    http://canadiancouchpotato.com/2011/06/30/the-stock-pickers-quest-for-alpha/
    http://canadiancouchpotato.com/2011/01/05/what-do-you-want-from-your-investments/
    http://canadiancouchpotato.com/2010/04/17/review-why-smart-people-make-big-money-mistakes/

    But as I’m sure you have found in your dealings with investors, it is a long and difficult road, and some people will simply never embrace passive investing. It’s one thing to accept the academic arguments (which are unassailable), but it’s another to actually internalize the ideas. I actually find index investing far more liberating than picking stocks, because I know that I would beat myself up for making bad picks. Some people, clearly, have the exact opposite view, and I’m not comfortable simply telling them they’re wrong.

  9. Larry Swedroe March 19, 2012 at 11:20 am #

    My pleasure, and I agree completely with your comments.
    Passive investing is enormously liberating. In fact what readers of my books tell me is that the single most important thing I have done for them is that they no longer spend time watching CNBC, reading investment porn, and so on. And they therefore get to spend more time on the really important things in their lives. They have learned that passive investing is the winner’s game in life (as well as investing), and that is far more important game to win!!
    Best wishes
    Larry

  10. Eric March 19, 2012 at 12:43 pm #

    I totally agree with you: (I actually find index investing far more liberating than picking stocks). But if an investor feels more confortable with div growth stocks, there are index ETF’s that are passively managed and follow that strategy. Standard market indexes (S&P 500, TSX) have never been introduced to be investment vehicles.
    Who knows 30 years from now; div growth stocks index ETF’s might be the clear winners. As for picking stocks, it’s always difficult to make the difference between a good cie & a good invstment.

  11. Larry Swedroe March 19, 2012 at 1:09 pm #

    Eric
    suggest you read my blog post on investing in fast growing dividend stocks. Evidence is no excess return and in fact looks like an S&P 500 fund with lot fewer holdings

    http://www.cbsnews.com/8301-505123_162-57384410/dont-rely-on-dividend-strategies-to-pick-stocks/?tag=mncol;lst;6

    At least you will be more informed having read it.

    if interested in evidence based investing, can sign up for RSS feed for the blog.

    Best wishes
    Larry

  12. Michel March 19, 2012 at 2:57 pm #

    Good stuff everyone! I like doing both (index funds/ETFs) and individual blue chip dividend paying stocks. I guess I get the best of both styles/strategies. I like everything that comes with buying indices and dividend stocks. Life is good!!!!

  13. The Dividend Ninja March 19, 2012 at 4:10 pm #

    Hi Dan, nice post :) At first I wanted to stay well clear of the debate here. However there was one point that stood out for me.

    The following statement I felt is an innacurate assesment. I don’t really think dividend investors would see the issue this way at all IMO:

    Their thought process goes something like this: “If I held index funds I’m afraid I would sell them if the markets tanked. But I take comfort from owning a basket of profitable, dividend-paying companies that I know will bounce back eventually. And for that reason, I’m more confident about staying the course.”

    I can’t speak for other investors, and I wouldn’t claim to, but my thought process goes something like this:

    My thought process goes something like this: “If I held index funds I’m afraid I would lose half my portfolio value if the markets tanked. But I take comfort from owning a basket of profitable, dividend-paying companies that I know will continue to pay me dividends regardless of their share value, and will bounce back eventually. And for that reason, I’m more confident about staying the course.”

    Anyway at the end of the day, we can sit down and have a nice cold beer and call it a day, and talk about somehting less contoversial such as religion and politics. You think? :)

    Cheers
    The Dividend Ninja

  14. Phil March 19, 2012 at 4:29 pm #

    Great comments! Larry in your article did the “dividend strategy” include reinvested dividends in the calculations?

  15. Canadian Couch Potato March 19, 2012 at 4:41 pm #

    @Ninja: I would sit down for a beer with you any time. :)

    But I would point out the idea that a portfolio of familiar companies is less risky than the overall market is probably the biggest misunderstanding that Larry and others have tried to dispel. This idea has great intuitive appeal, but no evidence to support it. Blue-chip dividend payers fell just as hard in 2008. Both CDZ and XDV (if we can use these as proxies) were down 30%. The DJIA lost even more, and those are the bluest of blue chips. It’s also important to note that small cap stocks (mostly unfamiliar, but included in total-market indexes) recovered much faster in 2009 in both the US and Canada. XIU (big blue chips) was up 31.5%, while XCS was up 61%.

    I accept that investors may feel more confident that familiar companies will recover faster, and that this will help them hold on, and there is value in that. But I do think we need to make a distinction between perceived risk and actual risk by looking at actual data, not anecdotes.

  16. Larry Swedroe March 19, 2012 at 5:22 pm #

    Phil
    Anytime you see returns data from me it will always include reinvested divs –only right way to do it
    Best wishes
    Larry

    And for I also agree with the couch potato, one of the worst and most persistent behavioral errors is that investors confuse the familiar with the safe. Just because something is familiar doesn’t make it any safer, that’s just an illusion, and it is mistake made by investors all over the world.

  17. Larry Swedroe March 19, 2012 at 5:24 pm #

    By the way it is an illusion that if you know the companies that the dividends are safe. Just think what would have happened to dividends if the great recession turned into the next great depression because of a policy mistake or global political problem.

    Larry

  18. Chris March 19, 2012 at 7:51 pm #

    Larry Swedroe tends to reinforce his own biases. The article of his that he linked to, for example, doesn’t support the superiority of index investing. At best, all it indicates is that there is no statistically significant difference between returns from dividend investing and index investing… but his confirmation bias leads him to present it in an odd way, as if it demonstrates something about the superiority of index investing. (Not to mention, he’s comparing *index returns*, without MER, against actual returns from holding individual stocks. You’d almost certainly get a statistically significant result if you did a fair comparison with the same dataset, assuming a tax-sheltered account.) And he completely ignores the experience of the last decade, in which absolute-return focused strategies like dividend investing tended to outperform.

  19. Canadian Couch Potato March 19, 2012 at 8:20 pm #

    @Chris: I’m not sure he ignores that dividend strategies outperformed over the last decade. It’s just that lots of odd things happened over the last decade that are unlikely to continue: T-bills outperformed the S&P 500, for example. But you’re right—I think we all fall prey to confirmation bias at times.

    It makes sense that a broadly diversified portfolio of dividend stocks (that means at least 100 stocks, not a dozen hand-picked favourites) should perform very similarly to the broad market over the long term if it has similar exposure to the size and value factors. It might even even outperform if it has higher value exposure. (Dividend investing is a mild form of value investing.) The article that Larry links to would seem to confirm that, and Fama and French would not argue with it either.

  20. Jon Evan March 19, 2012 at 8:34 pm #

    Dan, you make a provocative statement that you may want to qualify when you say “the data are clear that passive investing, when executed properly, is the optimal strategy”. Those of us who utilize evidence based practices everyday know too well that what is true today based on credible research can be false tomorrow when new contradictory studies turn up. While today there is good evidence that passive investing is correct in ten years new evidence may dispute that dictum and so investing cannot be solely that objective. There are still active investors around like Tom Bradley and your statement above then becomes too dogmatic and labels him as suboptimal and I know you don’t mean that. I abandoned stock picking for all the reasons that you repeatedly mention. It is too time consuming and there are more important things in life. Passive investing may be debunked or modified years from now, but I don’t think I risk losing my retirement investing that way. However, I’m not sure the case is closed regarding passive investing. Hopefully I’m wrong :)!

  21. Canadian Couch Potato March 19, 2012 at 8:50 pm #

    @Jon: This is a huge issue and I’m not sure I want to go down this road again. But to clarify what I meant: passive investors must as a group outperform active investors as a group after costs. That’s just math, and it can’t be debunked—even the most ardent active manager would concede that. That certainly doesn’t mean every passive strategy (or every passive investor) will outperform every active strategy over any period, no matter how long. There will always be better strategies in hindsight. But the optimal strategy would be the one that puts the probabilities in your favour as much as possible. Optimal is not perfect, it’s just the best we can do.

  22. My Own Advisor March 19, 2012 at 10:06 pm #

    Dan, you put things in writing so much nicer than I do! Well written stuff, but I expect nothing less.

    Thanks for highlighting my article and also, opening a discussion (not a debate) on this issue.

    Passive investing, is indeed going to give you the best chances at investment success – because you are riding a benchmark and benchmarks by design, are neither superior nor inferior. I don’t know enough about investing to date, to determine what benchmarks are optimal or not but I’m guessing there isn’t one. As such, this is why indexing works – invest in many broad-markets since you don’t know what will rise, what will fall and what stocks will be born or die within them.

    One the challenges I have with index investing, even though I index most of my RRSP myself, is that index funds do not offer much protection from market declines. When things crash, your value goes down with it. This can also occur with stocks, but with some established companies you get paid handsomely to wait out the storm.

    I totally get where Larry is coming from, familiarity in some companies is likely a false sense of security that really satisfies the emotional arm of the investor. I can feel that myself sometimes so I don’t dispute that. What I struggle with, is the generalization that “buying what you know doesn’t make sense.” If you are diversified, and you buy most of the companies in XDV or a related dividend-fund, I see no difference in buying this ETF and paying management fees versus owning the stocks directly and paying no fees.

    I’d like to propose that dividend-investing and indexing have much more in common than people think, especially if the approach is to focus on increased diversification over time, buying equities when the market slumps and maintaining a long holding period. Almost every book I’ve ever read about investing, can be sumed up in a few key objectives: avoid tinkering, stay invested for as long as possible, keep your costs low for as long as possible and diversify as much as you can.

    BTW – count me in for a pint of beer as well. This long comment made me thirsty! :)

  23. Potato March 19, 2012 at 10:18 pm #

    “The biggest issue with buying what you know is that investors confuse information with VALUE RELEVANT information.”

    Larry’s point here is particularly relevant when you’re talking about investors underperforming and over-trading in professionally close stocks. And of course that distinction (professionally close stocks as buying what you know) was part of the talking past each other that was happening at MOA.

    I’ve seen it myself a few times. One example was a friend who worked in a low-level position for one of the big telcos. Based on things he would see (satisfied vs. dissatisfied customers, how excited management was over the latest gizmo they were pushing the reps to sell to the customers) he would buy or sell stock. Though they were big parts of his day-to-day, they were meaningless bits of trivia to base an investment decision on.

    Or another friend who would watch KFC locations, and confirming that business volume hadn’t slowed down, invested in Priszm. Unfortunately while volume stayed up, profitability there slid, and more important was the high cost of the franchise agreements. The ending was not pretty for investors, even though people still piled in for their twonie tuesday chicken fix.

  24. Doug Cronk March 19, 2012 at 10:19 pm #

    Hi, Dan.
    It’s such good news to see so many more individual investors ‘converting into a dividend investor’. But I’m fascinated that some continue to (try to) pick individual dividend paying stocks. Why not buy a dividend ETF? XDV or CDZ … or both?
    … thereby avoiding ‘accidents’ like SNC Lavelin … until recently a nice and steady, dividend paying stock.
    http://www.theglobeandmail.com/globe-investor/markets/stocks/summary/?q=SNC-T

  25. Canadian Couch Potato March 19, 2012 at 10:40 pm #

    @MOA: Next time I’m in Ottawa, the pint is on me. :) One important point I would like to address in a future post is how one defines being diversified. Buying both CDZ and XDV, plus a US dividend ETF with 100+ stocks, sure. Picking 10 or 12 Canadian favourites? Definitely not. A topic for another day.

    @Potato: Yes, another thing that has gotten lost in the discussion was that the study Swedroe initially cited was about “professionally close” stocks, where the investor believed he or she had some inside knowledge based on working in the industry. Key lesson here: don’t eat at KFC.

    @Doug: Good point. It is certainly possible to be a dividend-focused investor without taking on single-stock risk. This is especially true in the US, where there are excellent low-cost ETFs with 100+ stocks.

  26. The Dividend Ninja March 19, 2012 at 10:54 pm #

    @CCP re Chris
    Lowell Miller who has an impressive academic background in economics, who has done the research, and who has actually invested millions on behalf of others recommends holding only dividend stocks, in The Single Best Investment. FYI (as you probably already know) Miller recommends 30-40 blue chip dividend stocks as the optimal holding. His research indicates that holdign fewer than 30 stocks is not a sufficient level of diversification, and that holding more than 40 leads to diminished returns.

    CCP, the point I was trying to emphasize in my previous comment was that you had made an assumption of what you thought dividend investors think – which I believe was an incorrect assumption.

    Dividend stocks provide you income regardless of share value. If the market tanks 30% as an example, you still receive the same dividend income. I was simply saying I would rather receive the dividend income from large well-established companies, even if the share price declines, than hold an index fund that has declined in value and pays me no income at all. All the aristocrats as an example (which I know you think is a faulty investment strategy) did not cut their dividends in 2008 and 2009, and actually increased them.

    @LS
    “Just think what would have happened to dividends if the great recession turned into the next great depression because of a policy mistake or global political problem.”

    Well it was that close wasn’t it? At least it sure felt that way in early 2009… But I don’t think Index Funds or Index ETFs would fare much better either, or even provided more safety. In fact I would argue that if you held companies like JNJ, MCD, PG, among others (even if they temporarily suspended their dividends) that you would be in a safer position than holidng index equity ETFs. At least you would actually own the company instead of a fund.

    “one of the worst and most persistent behavioral errors is that investors confuse the familiar with the safe.”

    I would agree with you on that LS ;) But I would also argue companies like JNJ and KO,MCD etc. are pretty safe.

    Cheers

  27. Larry Swedroe March 20, 2012 at 9:28 am #

    Few comments on the responses above

    Chris
    First, the article had nothing to do with indexing or its superiority. So if there is a bias, it is yours, reading something that was not there.
    Second, there is a whole literature on the superiority of indexing/passive investing over active investing. If you care to read a summary of it, try the Quest for Alpha
    Third, there is no superiority of dividend strategies in the last decade. I showed that in the piece, you just have to understand what you own, a VALUE oriented low beta strategy that is woefully undiversified relative to a broad global portfolio

    Re 30-40 stocks being enough to diversify. It isn’t even anywhere near to close enough. The academic research on US stocks now is that for the asset class of just US large you need at least 50 to get tracking error down to just 5% (might not be enough for most people) and for small its well over 100 and then add other asset classes like international and EM and RE, and you are way beyond what any individual can reasonably do, and you can get index funds for very low costs and eliminate the idiosyncratic risks

    Dividend Ninja
    “Dividend stocks provide you income regardless of share value. If the market tanks 30% as an example, you still receive the same dividend income”
    As to the idea that dividends are safe –that is just simply wrong. For example S&P 500 divs were cut over 20% from 08 to 09 and you can only imagine what would have happened if the recession had actually turned into the next great depression as many had predicted. Divs are no way to substitute for safe fixed income, simply a value oriented equity play with lower beta. Of course the index funds would go down, but the safe bonds you should have held instead of div stocks went up!!!

    Jon—passive investing MUST be the right strategy in aggregate. That is simple math, not academic theory. It’s the cost matters hypothesis. In aggregate passive investors must outperform active investors. The only issue remaining is can one identify in advance the relatively few outperformers. Perhaps someone will figure that out, but not so far. And even if they do it will not persist because money will flow to those with the skill based alpha and cash flows will lead to its destruction. If interested in very good paper on subject suggest reading Berk’s The Five Myths of Active Investing

    My own advisor–true that indexing doesn’t protect you from bear markets, but neither does active investing. The evidence shows that active managers actually do slightly worse in bear markets than they do in bull markets, which is bit shocking since they have the supposed advantage of being able to go to cash.

    Potato
    As to the friends who watched the KFC store, that is one of the worst and most common errors, confusing information with value relevant information. The friend fails to ask: I am the only one watching the traffic? Are the big institutional investors totally ignoring this, and I am only one who knows? No one else thought to watch the traffic?

    Best wishes
    Larry

  28. Michael James March 20, 2012 at 9:44 am #

    @Larry: You’re tireless (I mean that as a compliment). I fear that for some, dividend investing provides emotional benefits that won’t yield to evidence or logic.

    I used to think like Potato’s friend who bought KFC based on some peronal experience. Looking back at my own investing record, “buy what you know” was a waste of my time and money. I took some insane chances and was fortunate enough to make 3 wildly lucky trades in my employer’s stock; otherwise my record was dismal.

  29. SterlingF March 20, 2012 at 10:33 am #

    This blog and the quality and knowledge of the commenter’s is awesome! I’m sure I’m not the only one but I will comment just so I can get email notifications of new comments and stay informed.

  30. Larry Swedroe March 20, 2012 at 10:40 am #

    Michael
    My pleasure, it’s my way of giving something back, helping others.
    Best wishes
    Larry

  31. Jon Evan March 20, 2012 at 1:30 pm #

    There is more to investing than ‘performance’. There is also risk. Buy & hold has that weakness in that people abandon ship when markets tumble. Assest allocation does not completely solve that. An investment strategy needs to consider both because of this human behaviour which worsens as one ages! There will always be further research to define/refine passive investing. Currently, there is an interest in VII (valuation informed index investing).
    http://www.mypersonalfinancejourney.com/2011/05/valuation-informed-indexing-vs-passive.html
    I’m not convinced that passive investing won’t yet see further modification.

  32. The Dividend Ninja March 20, 2012 at 1:34 pm #

    @LS
    Thank you for the follow-up comment, and your replies – there is certainly much food for thought. ;) I still retain as close to a 40% bond/fixed-income allocation as I can at my age. I do believe bonds provide a harbour of saftey amidst market turmoil, they certainly did for me back in 2008 and 2009. Some investors choose a 100% dividend stock portfolio, but I think any portfolio that is 100% equity (dividends or otherwise) is high risk IMO.
    Cheers and thanx.

  33. Larry Swedroe March 20, 2012 at 1:46 pm #

    dividend Ninja
    An all high dividend strategy is really more like 2/3 stock and 1/3 bonds in terms of risk, not 100%. See my blog on that subject

    John, buy and hold is not weak, it is the weakness of the individuals that don’t stick to it. Also note that human behavior actually tends to bet better as we age, that is what the research shows. For example we tend to be less confident and thus diversify more.

    And I do agree that we will likely see more “enhancements” to a passive approach. It used to be just about beta, then three factors, then added momentum and now gaining exposure to more sources of returns. If want to see the state of the art would urge you to read Antti Illmanen’s Expected Returns.

    Best wishes
    Larry

  34. Chris March 20, 2012 at 8:20 pm #

    @Larry: Many of the statements you’ve made are not accurate. For example, it is not true that dividend stocks have underperformed the indexes over the last 10 years. Moreover, I do not follow your argument that: “As to the idea that dividends are safe –that is just simply wrong. For example S&P 500 divs were cut over 20% from 08 to 09 and you can only imagine what would have happened if the recession had actually turned into the next great depression as many had predicted.”

    What exactly are you trying to say? Individual stocks may cut their dividends, but there’s absolutely no question that since the second world war dividends have been far less volatile in aggregate than either stock prices *or* bond prices. Consider this chart of the S&P 500 aggregate dividend (not yield… aggregate dividend): http://www.multpl.com/s-p-500-dividend/ The 2008 financial crisis is just the mildest of blips on that graph. This is why it’s perfectly legitimate for *income-focused* (rather than total return focused) dividend investors to consider dividends a much safer strategy than investing in indexes.

  35. Michael James March 20, 2012 at 9:11 pm #

    @Chris: Not that Larry needs any help, but it makes no sense to compare dividends to index returns. I could buy $100,000 of some index and sell exactly $3000 worth each year to create an income stream with no volatility at all. Businesses that pay dividends are motivated to keep the payments stable even if their earnings are not stable.

  36. Larry Swedroe March 21, 2012 at 8:55 am #

    Chris
    I did not say that dividend stocks underperformed, I said there was no superiority of them. What I said, and if you read the articles on my blog, is that dividend stocks are not replacements for safe fixed income, as many people believe and is being touted, nor are they anything more than investments in value stocks (and a weak value strategy at that, meaning there are better value strategies)

    Also yes dividends are more stable than stock prices, but that doesn’t matter. What matters is are they more stable than safe fixed income investments. And the answer of course is no, and thus they cannot be a replacement for them

    On your last point, being a blip on the graph, we only know that AFTER the fact. It was not destined to turn out that way.

    Again a high div strategy is nothing more than a lower beta but with high tilt to value strategy. That’s it.

    This is how it works.
    Say you are 50/50 stocks and bonds, $100,000 in each.

    Now someone convinces you to move your bonds to a high div strategy. So now you are no longer 50/50 but about 83/17 with all the risks that entails. There is a much better way to achieve the same objective, more diversified.

    There is nothing logical or special about a high div strategy nor a strategy that invests in stocks that have fast growing dividends.
    If are really interested in the fact check this blog post out.

    http://www.cbsnews.com/8301-500395_162-57383053/the-dangers-of-dividend-paying-stocks/?tag=mncol;lst;9

  37. Monevator March 23, 2012 at 11:55 am #

    Super article, and one that mirrors a lot of my own thinking as to why I run a portion of my funds actively. (With the addition that I don’t have to cover fees to myself, given I enjoy it so work for free, and that I have some (perhaps luck) evidence that I can do okay picking stocks).

    Will link to this tomorrow and make my own future post on the subject work harder. :)

  38. Canadian Couch Potato March 23, 2012 at 12:28 pm #

    @Monevator: Thanks for the comment, and for linking to my post. I think it’s fine to actively manage a small (hopefully very small) part of your portfolio if it means you’re more comfortable leaving the rest alone. :)

  39. Andrew March 23, 2012 at 6:57 pm #

    Spirited discussion.
    Regarding dividend investing: there are distinct tax advantages to dividend yield as part of total return in Canada particularly in certain situations such as higher balances in open accounts and where say there is not a high income otherwise. From the total return perspective there is there may be an advantage toward a mid beta, value oriented, dividend growth tilt in the equity correlated part of a portfolio. Dividend growth companies also practice a discipline that adds value. Such a portfolio is difficult to achieve with what passive indexes that are out there (as far as I can tell).

    Therefore consider the following for part of the equity correlated allocation – passive dividend oriented indexes complemented by carefully selected companies (especially those that balance out the sectors of the ETF) with the above characteristics held for long term and rebalanced every several years. An added bonus to return are dividend reinvestment programs that offer discounts and limit transaction costs.

    I would like to hear anyone’s opinion of this.

  40. Canadian Couch Potato March 24, 2012 at 10:25 am #

    @Andrew: There is no question that it dividend-paying Canadian stocks enjoy significant tax advantages in non-registered accounts. But this is quite a different issue: someone relying on tax-advantaged dividend income should still be generated by a diversified portfolio rather than one that contains stocks that are hand-picked because of the investor’s familiarity with the companies and their products. And you may be surprised how many dividend-focused investors hold their stocks in an RRSP, where the tax advantage is zero.

    Note also that there are many ETFs that track indexes based on dividend growth, including CDZ in Canada and VIG and SDY in the US, so there is no need to pick individual stocks even if you choose to follow that strategy. I would argue the same is also true when looking to diversify across sectors: there are better ways to do this than picking individual companies.

Trackbacks/Pingbacks

  1. - My Own Advisor - March 22, 2012

    [...] Couch Potato attempted to make peace between opponents for and against “buying what you know”, in reference to my post last week. Dan said “As I read the post and the comments, it struck me [...]

  2. Investing Blog Roundup: Thanks for Spreading the Word - March 23, 2012

    [...] When “Buy What You Know” Makes Sense from Canadian Couch Potato [...]

  3. Weekend reading: Budget 2012 roundup - March 24, 2012

    [...] When ‘buy what you know’ makes sense – Canadian Couch Potato [...]

Leave a Reply