Rethinking Risk

[Robandcindy2]

Let me start by declaring that I am not a financial analyst, guru, expert, nor as you read on an english major, etc.  Secondly, we have a saying in the cockpit: "NEVER take financial advice from a pilot!" (Even if he did stay in a Holiday Inn Express last night).  That said, I offer up some observations that I gleamed from my latest research quest having just turned the Big Six Oh.

I left the USAF fighter-bomber world after ten years excitedly looking forward to a fun airline career which was going to make me retire at 60 with a nice lump sum retirement payout.  After all, it was written in the contract.  Bankruptcies happen, contracts get overturned, pensions get wiped out, retirement age increases, life goes on.  Hence began my affair with DGI.

Financially prudent parents raised me up as a "Boglehead" (Boglehead Forum).  Despite their own tragedies and financial fallouts they always managed to live a comfortable life while spoiling their grandchildren.  Bogleheads were the experts in "Lazy Portfolios" before there were such things (Lazy Portfolios).  And being a "Vanguardian" at heart to this day I prefer low risk and capital preservation.   Just as in the cockpit, the Sleep Well At Night (SWAN) approach is the safest.  While DGI is not necessarily a Lazy Portfolio, it can be accomplished with minimal effort and SWAN effects.

So in light of being over the hill, BREXIT, nine years since a major market correction, and putting the flaps out as I slow to "pre-retirement speed" I began to explore if I needed to "cushion" our DGI portfolio and add some risk protection by increasing our bond percentage.  This led to the poll to see where my DG friends stood on the subject.  If you haven't participated please consider it:

Asset Allocation Poll

For those just awakening to  the power of a sound DG portfolio let me point out one of the strongest arguments for choosing this path.  During recessions, while even a portfolio of 100% Dividend Champion Stocks (David Fish's Champions Spreadsheet) will lose value, it will A) lose less than a pure total stock portfolio, B) will recover lost value faster, and C) will continue to raise it's dividends (income!) even during the recession.

Contrast this with Modern Portfolio Theory and The Efficient Frontier.  As the above poll and many Seeking Alpha authors attest to, DGI minimizes risk through quality companies that offer some bond like replacement qualities (lower risk, stable to increasing yield).  Again, for those new to DGI, a dividend paying stock, no matter how long that company has paid dividends is not a bond.  I won't digress into that discussion but please remember that.

In what we are being told is a "rising rate environment" about the only argument one can make for bonds is that they help cushion capital preservation during down markets.  Yields are dreadfully low.  In a rising rate world, bonds you own will lose value as corresponding rates eventually rise.  As the graph below of the Vanguard Total Stock Market Admiral Fund (blue) vs the Vanguard Total Bond Market Admiral Fund (red) shows during down markets (Recession 2009) bonds minimize losses and albeit briefly, outperform stocks.  In fact, if you invested $100,000 in each fund in 2007, the Total Stock portion would not catch up to the bond portion until 2013.

   
Portfolio Visualizer

The question then becomes "how much should you hold in bonds?"  This question is really best translated to "how much risk do you want to take?"  Back to The Efficient Frontier we learn that it is possible to build a portfolio of stocks and bonds (and other vehicles) that will provide a certain theoretical return for a certain theoretical risk.

   

To quote Clint Eastwood in Dirty Harry, "Do you feel lucky?  Well?  Do ya?"  

Len Morgan, a former airline Captain and writer for Flying Magazine once wrote about those smooth, grease job airplane landings, "The first one of the trip is skill, two in a row is luck, three grease jobs in a row?  Somebody is lying!"  Applying the traits of quality dividend stocks to the above premise we arrive at the soft landing feature of DGI.  Always smooth?  Hardly.  But certainly more comfortable than the alternative.

For these closing examples we are going to tap into Seeking Alpha author Mike Nadel's series of articles based on the New Nifty Fifty which he now refers to as the DG50.  I can't recommend any more highly that one consider Mike (and the panelist's) recommendations for a portfolio starting point.  Currently several stocks in this portfolio do not meet the criteria of David Fish's Champions spreadsheet having reduced their dividends.  So from a pure, recession proven perspective some companies have slightly greater dividend growth risk.  Companies do reduce or freeze their dividends for various reasons and only you will be able to decide if they should remain in your portfolio.  The DG50 is powerful nonetheless.

As I am prone to the capital preservation mode especially being very close to retirement I wanted to confirm our DGI premise that dividend growth stocks cushion our ride.  Again utilizing the Portfolio Visualizer website, I loaded the DG50 with a few modifications to compare and contrast historically.  But first the modifications.  I sympathetically applied Mike's follow-on article Coulda-Woulda-Shouda and increased the DG50 to 61 companies.  After all I was going to compare this to the Total Stock Market.  Next, it was necessary to make some substitutions so that I could get Portfolio Visualizer to look back to at least 2007(RAI for PM; SYY for KHC; JPM for V; MMP for KMI).   And as Mike did, I created an equal weighting portfolio (as much as the website and my sanity would permit). 

   

This is the DG 61 (blue) vs the Vanguard Total Stock (red) vs Vanguard Total Bond (yellow).  Similar to the first Vanguard comparison, note the corresponding drop in value during Recession 2009 and the recovery time following the recession.  The 61 DG stocks overtook the "safe" Total Bond Fund two years sooner than the Total Stock Fund!

   

And in a similar fashion, adding a bond portion to a Dividend Growth Stock portfolio reduces your risk even further...but for a price.  Here I substituted the DG61 (pure stock) with the DG61+30% bond position (blue), Total Stock Fund (red) and Total Bond Fund (yellow).  One way to look at it is for a $20,000 reduction in growth (DG61 vs DG61+30% Bond) you can buy 4% of standard deviation or reduce your pain by almost 8% during the worst year.  Which to you value more, potential gain or lower risk?

Of course this isn't the whole story.  If you have a crystal ball and can time a portfolio adjustment perfectly then you really don't need our forum.  Since I have a life to live and grandkids to enjoy, I would prefer a portfolio with a nice autopilot.  So let's zoom out and compare the DG 61 stocks with a 30% Total Bond portion(blue) with the Vanguard Total Stock (red) and the pure DG 61 stock portfolio without bonds(yellow) over the 2007-2015 time frame:

   

First, in 2009 we note that as discussed, the DG 61 suffered less of a loss during the recession and the DG 61 with 30% in Total Bond suffered even less.  By 2011 the pure stock DG 61 had caught and surpassed the DG 61/Bond portfolio.  However, for me, the Go-No Go decision is riding that red Total Stock Market line.  When all was said in done, our $100,000 invested in 2007 reached $238,000 using the pure DG 61 portfolio as compared to $167,000 using a Total Stock portfolio.  And if I wanted to give up some gains for short term recession peace of mind, the DG 61 plus Bond produced over $40,000 more in returns than a Total Stock market portfolio.  From the Fall of 2008 to the Spring of 2009 the DG 61/Bond also lost approximately 8% less than the pure DG61.

Conclusion

There is ample evidence that a sound dividend growth portfolio composed of companies that have increased their dividends every year for a minimum of 8 years (at least starting their increasing trend prior to and continuing through recession 2009 to today...the longer the better) will weather market down turns better a Total Stock Market Portfolio.   It is also possible to minimize portfolio risk with the careful addition of quality bonds.  This must be tempered with the warning that as bond yields rise, bonds will initially lose value which in turn will lessen the downside protection those bonds provide.  And remember too that a dividend paying stock is absolutely a different vehicle than a bond.  Finally, if you are an optimist and believe that the stock market will continue to climb as it has done since 1929, then a portfolio of quality DG stocks will provide growth, income from dividends and better downside protection than the stock market as a whole.

So I am comfortable being at roughly 75% DG stocks and 25% bonds for now.  At least until the Fed gets the first couple of rate increases under their belts.  Then we'll talk.

Again, I am not certified or licensed to do anything other than to fly you from A to B.  I have no formal financial training and the opinions expressed here are simply and totally based on my own research and should not solely be used without employing the readers own due diligence.  Remember, nobody cares more about your money than you do....

[Robandcindy2]

Folks, not sure why the images aren't appearing. My apologies......

[navyasw02]

Nice analysis. I think your numbers are skewed however because you assume no additional investments beyond your initial principal in your back tests. I rarely see any analyses that do include periodic investments, but they would significantly increase total return had the theoretical investor continued investing in that max drawdown period.

I don't pretend to have the right answer for what AA should be, but I see it largely depending on time remaining in the market. For me, I'm 100% stocks because I have at least 20 years of continued investments before I start to drawdown.

[Robandcindy2]

(06-28-2016, 01:23 PM)navyasw02 Wrote: Nice analysis.  I think your numbers are skewed however because you assume no additional investments beyond your initial principal in your back tests.  I rarely see any analyses that do include periodic investments, but they would significantly increase total return had the theoretical investor continued investing in that max drawdown period.  

I don't pretend to have the right answer for what AA should be, but I see it largely depending on time remaining in the market.  For me, I'm 100% stocks because I have at least 20 years of continued investments before I start to drawdown.

You are correct.  And with 20 to go I would (and was) 100% stocks.

Here is the DG61 (blue) DG61/38Bond (red) and 60/40 (yellow) with contributions of $458/month ($5500/year) vs S&P 500 Total Return in green:

   

[crimsonghost747]

Thanks for making an indepth article.
One thing though that catches my eye... and I see this all the time in each and every single article that mentions bonds. And that is bonds and them losing value when the rates go up. Yes, it's true that the market value goes down. And I see why everyone mentions this: it's because the large majority of people own their bonds through an ETF instead of owning individual bonds.

I personally opt to own individual bonds. And when I buy a bond I will hold it until maturity. And really there are only two things to consider: yield to maturity and risk profile of the company in question. Maturity date is of course an important factor too but it doesn't really affect what you will be getting out of that particular bond, rather it just defines when you will need to reinvest that money. If I'm getting the bond with a yield to maturity of 4% / year, then I'll get exactly that no matter what the interest rates are tomorrow. They could be 0%, they could be 15%... it simply makes no difference to the bond I'm holding as the coupon payments remain the same and the facevalue remains the same.

Juggling bonds frequently is a whole other game but since most of us have a buy&hold tactic with stocks, why wouldn't we use the same tactic with bonds? When bonds are being utilized like this, the only risk really is that the company will not be able to pay back what they owe you.

[cannew]

When saying bonds preserve capital, people rarely mention the loss of purchasing power due to inflation.  With the stocks I own they may go down during corrections, but generally recover and continue to grow as the dividend grows.

I'm 74 and our dividends more than exceed our expenses, so our capital continues to grow.  I would not have bought bonds during our accumulation phase, so why would I want them in retirement (guess if one needed to live off their capital, then there might be some justification).

I would also not buy bond etf's or any etf's.  There is no guarantee of capital with bond etf's.  We no longer buy or sell which means there are no annual expense fees, regardless how small.

[O'Bazooka]

Sorry to lift this old thread, but isn't there a strong dividend survivorship bias (maybe other than JPM) in your reasoning? Also can't see the pictures if they worked in the first place. I think after reading the DG50 posts of Nadel that the point is to follow the performance of collective DG approach going FORWARD from the selection moment. Looking back is dangerous if the selection is made using present knowledge. I'm not saying DGI is flawed, this conclusion just seems too optimistic.

[EricL]

I don't know how I missed this originally, it's really an outstanding piece of work, and gives me encouragement that sticking with DGI is the way to go for the long run for my portfolio.

This would be an excellent piece for Seeking Alpha, I'm sure it would generate a ton of discussion.

[O'Bazooka]

No but seriously I can't see how this calculation would be unbiased. Only looking at survivors is the biggest problem I have about the arguments and articles for dividend growth investing. Again, I'm NOT attacking the conclusion that dividend growth may well be a criterion leading to market beating or at least matching and less volatile returns . But those comparisons only seem to suggest that your DG61-portfolio was better than the total stock market, which should be clear when selecting them using data available after the studied period.

Could you run a similar backtest with maybe the aristocrats of 2007 or someone's handpicked portfolio of DG stocks from that time, actually posted somewhere before the crisis? I came across this list of aristocrats from 1989:
http://www.valuewalk.com/2015/05/list-of...9-to-2014/

What I'm suggesting is something like watering down the superstars from this article:
https://seekingalpha.com/article/2148343...89-to-2014
Here there is also a clear survivorship bias, as nobody should think they would have picked exactly KO, PG, LOW, JNJ, MMM, EMR and DOV from the 26 choices in 1989 and seen those sky high returns. But the real question I think is just how great were these returns: From the list above also CL, PH and GPC actually managed to raise their dividend to this day. Add 3 more companies which I (born after 1989 ) recognize and are still operating, namely K, TMK and IFF. Here are the total returns of these 13 companies between 1/1/1989 and 6/30/2017:

KO 2929%
PG 3158%
LOW 16266%
JNJ 4690%
MMM 2924%
EMR 1644%
DOV 2179%
CL 4709%
PH 3296%
GPC 1424%
K 850%
TMK 2969%
IFF 1585%

That's an average return of 3740% i.e. $13,000 put equally in each stock would now be worth approx $499,000, which equals CAGR of 13.655%. Compare this to $13,000 invested in S&P500 or the Wilshire 5000 which would have turned to approx $210,000 or $213,000 respectively during the same period, CAGR approx 10.3%.

So the "best" 13 of 26 had significantly superior returns than the market. How to account for the obvious survivor bias? The return of this half of the sample was in fact more than double the return of the market!!! Meaning that if you had put $1000 in each of the 26 stocks, you would have gotten a better return than putting $1000 in only in these 13 and burning another $13,000 in a campfire, which in turn would actually had gotten a better return than putting $26,000 in either of these indexes.

There's of course the another 13 stocks which would likely returned real money as well. A pitfall is the huge run of LOW, which should have been left untouched with no balancing and imagine if someone would have chosen only all the other 25 names? I'd really like to see an actual total return of all the 26 aristocrats of 1989, some have been aquired etc. I got my numbers using that Seeking Alpha article and the total return calculators on dqydj.com, and there might be tiny rounding errors.

Sorry for the long post and again for lifting this old thread, I'm just really thinking over and over about just going the index route and want to eliminate all possible pitfalls in the arguments favoring stock picking dividend growth stocks. At least for the last 28 years the approach seems legit, but that isn't a long enough time frame to draw too certain conclusions. What I'm mostly worried now is that since the late 80s the interest rates have been declining, how will this strategy fare if they steadily increase to 6-10% in the next 15-20 years?