There is nothing fundamentally wrong with a strategy of assembling a diversified portfolio of dividend paying stocks purchased at reasonable valuations and holding it for the long-term. Such a portfolio is likely to (more or less) provide the benefits that come with long-term stock ownership. This old strategy has been (and continues to be) profitably employed by countless investors and went awry for Derek Foster for a variety of reasons, almost all of which can be traced back to one cardinal error — too much focus on rewards and not enough on the risks:
No allocation to fixed income. Bonds may be boring but in periods of market stress, they can be counted on to provide income. Dividends or distributions provide no such guarantee and it is risky for retirees to solely rely on dividends to pay the bills. Even long-term investors can add some stability to their portfolio by allocating a small portion to bonds and rebalancing occasionally. A 100% allocation to stocks should be made only after careful deliberation.
Making concentrated bets. In an interview with James Daw (“Happily Retired at 34”, Toronto Star, Sept. 26, 2006), Derek Foster said that he had 20 percent in Canadian Oil Sands Trust (COS.UN) and 37 percent in oil and gas producers. Initially, it turned out brilliantly — oil prices kept going higher and higher and then crashed taking the portfolio down with it. From a cash flow perspective, distributions from just two energy holdings contributed more than half of the portfolio’s income in 2008. When those contributions were cut, the income from the portfolio dropped precipitously.
Aggressive withdrawal rates. Conventional wisdom suggests that investors retiring at the traditional age can safely withdraw 4% of their portfolio in the first year. But even a 4% withdrawal rate is probably too aggressive for young retirees whose portfolio needs to last lot longer. Derek’s withdrawal rate was even more aggressive and would have depleted the portfolio in short order but for the income from book sales.
Extrapolating recent trends. The 2000 to 2008 stretch was a glorious time – many blue-chip companies boosted their dividends at a torrid pace and it was easy to believe that the happy trend will last forever. But dividend growth has a speed limit – in the long-term, dividends cannot increase at a faster rate than earnings and earnings do not grow in double digits in mature economies. Incredibly, Derek is at it again, arguing that his profits from selling puts is proof that the new strategy of “money for nothing” is working.
Investors following the dividend strategy while paying attention to the risks outlined here are likely to experience financial success. Investing is always about managing risks — the returns are up to the market gods. [Note: Four Pillars alluded to some of these points in yesterday’s post but I wasn’t in the mood to rework mine.]
