This is the second half of an interview on Dividend Investing
I began with Dan a couple of weeks ago. If you haven’t already be sure to read Part-1. In that interview I asked Dan about dividend investing in general, and passive index versus dividend strategies. The inspiration for this interview is from the Debunking Dividend Myths series which Dan wrote on his blog in January and February.
For those of you who don’t know Dan, he is an advocate for Index Investing, and his knowledge of this subject is extensive. His blog the Canadian Couch Potato is a fantastic resource for both the novice and experienced investor. Dan is also an accomplished author, and for more than 10 years he has contributed regular articles for Canada’s MoneySense magazine.
Hi Dan, welcome back and once again thank you so much for taking the time for this interview! In this second half we discussed funding retirement through dividend income, the buy what you know strategy, and global diversification. Shall we get to it?
Bring it on, Ninja.
Dan, in Part 3 of Debunking Dividend Myths, the issue of funding retirement income became quite apparent through the comments. The financial experts seem to agree that 4% is the golden rule -the amount you can safely withdraw, before you deplete into capital. Yet most blue-chip dividend stocks (excluding income trusts and smaller caps) have around 3% to 3.5% dividend yield. For example purposes let’s say the portfolio yields an above average 4% in dividend income and approximately another 5% per year in capital growth. So why can’t a primarily dividend paying portfolio sustain retirement income?
That’s a great question. It’s really important to understand the underlying assumptions of that 4% rule. That research is based on investors who hold a balanced portfolio of about 50% fixed income and 50% equities. A portfolio like that will clearly have much lower expected returns than a portfolio that is entirely made up of equities (whether they are dividend stocks or not). Of course, it will also be much less volatile.
So to answer your question, if your retirement portfolio was 100% dividend paying stocks, it almost certainly could sustain an annual withdrawal rate higher than 4%. William Bengen, who did the research, argues this explicitly. He actually encourages investors to hold as much in equities as they can stomach.
Unfortunately, many people simply do not have the fortitude to hold 100% of their retirement portfolio in equities. During an event like we went through in 2008–09, retired investors endured an enormous amount of stress. Yes, many companies continued paying dividends, and over the last two years the market has come back virtually all the way, but it sure didn’t feel like that in February 2009. Retired investors who panicked and sold their stocks were decimated. Those who had a balanced portfolio had a much easier time staying the course.
In Part 4 of Debunking Dividend Myths, you bring up the dividend investing strategy of “Buy what you know”. I think most dividend investors would agree that buying big brand name companies, with recognition, and holding to collect the dividends is a sound strategy. I don’t think dividend investors are necessarily trying to beat the market as you imply.
Investing in the “broad market” as you suggest, means an investor is placing faith in a lot of unknown companies. So how can you go wrong with buying a basket of solid blue-chips like McDonalds, Johnson and Johnson, Husky, TD Bank, or Starbucks?
Your assumption here is that a good company is the same thing as a good investment. Of course McDonald’s, Johnson & Johnson, Husky, TD Bank, and Starbucks are profitable, and you are unlikely to get into big trouble with them. However, if blue-chip stocks are recognized as being safer than the overall market, they cannot also be expected to produce better-than-market returns. You pay a premium for safety. If you didn’t, then investing would be a no-brainer.
The irony is that the “bad” companies often turn out to deliver the highest returns. Because people have such low expectations of them, they are priced cheaply, and if they do better than expected , they can be outstanding performers. That, after all, is the essence of value investing.
Andrew Hallam just did a fascinating post on his blog that gives some real examples. About a year ago, he asked people to pick the worst stocks they could possibly imagine: the ones they thought were certain to end up in the toilet. On average, those stocks are currently up more than 8%. Several are up more than 20%, and two (including Krispy Kreme) have gained about 50%. The key point is that it doesn’t matter whether TD Bank is a “better” company than Krispy Kreme. It always comes down to the price. And consistently identifying underpriced securities is much more difficult than it sounds.
That’s why I believe the best strategy is to simply buy the whole market at the lowest possible cost and assume that most stocks are fairly priced. Undoubtedly there are price anomalies, but they cannot be reliably exploited.
Thanks Dan, excellent point. I did read the article by Andrew Hallam and it is indeed fascinating.
In Part 5 of Debunking Dividend Myths, you discuss the issue of global diversification as it relates to Canadian investors who hold primarily Canadian stocks in their portfolio. Your view would be there is less risk by investing globally than domestically. Why?
The first thing to understand here is that investing in any developed market should carry approximately the same amount of risk. Equity markets in Western Europe, Japan, the United States, and Canada have produced broadly similar returns over the very long term. So it’s not a matter of Canada being high-risk. It’s more a matter of concentrating too much on a tiny, poorly diversified economy that is exposed to some very specific risks, like commodity prices.
Even though all of the developed markets have produced similar returns, they have not followed the same path. They have all had periods of outperformance, and other periods where they have lagged the rest of the world. By holding a globally diversified portfolio and rebalancing it regularly, you should be able to enjoy higher long-term returns and lower volatility than if you focused on a single country.
Yet global diversification did not protect investors from the 2008 and 2009 market crash. In fact Europe was a mess, and still remains so with other countries on the verge of default. The US is just starting to recover with a frail banking system, and Japan is still a deflationary mess from its meltdown in 1989. Any many countries have systemic corruption and violence that makes doing business with them virtually impossible.
Here is another idea that won’t seem to go away: that a diversified equity portfolio will prevent you from losing money in a global economic meltdown. No one has ever promised that. During events like we experienced in 2008 and 2009, all risky assets lost value.
However, true diversification means building a portfolio that also contains asset classes that are not highly correlated with equities. An allocation to government bonds helped immensely during the meltdown. So would some exposure to the US dollar, or a small allocation to gold. You still would have lost money, but you would have lost a lot less.
Fortunately, most downturns are not as widespread as the crisis of 2008–09. As you point out, the US, Japan, and Europe have all experienced difficulties over the last 30 years, but these difficulties have not all come at the same time, nor could they had been predicted in advance. Over the last 30 years, you would have had a smoother ride — and with regular rebalancing you may even have enjoyed higher overall returns — than if you had just picked one region.
Good point Dan. Right now Canada looks like a solid place to invest by many other worldwide investors and countries. Our banks are rock solid. Australian BHP attempted its takeover on Potash Corp last year, Globalive is trying to establish Wind Mobile, and China is actively working to invest in Canadian assets such as the oil sands and natural gas partnerships. While Canada is a small slice of the global economy, it seems everyone wants a piece of our pie. Your thoughts?
I don’t think the world is nearly as interested in Canada as we think. Do you think US investors are loading up on Canadian stocks? What about German pension funds? How about the Japanese? If you were watching the business news in France, do you think your reaction would be, “Wow, look how much the world is talking about Canada?” Of course not. They all have the same home bias that we do.
Yes, Canada has done very well recently, but over the last decade Australia has absolutely blown away the rest of the developed world with annualized returns of almost 15%. This is not one or two lucky years: it’s more than ten years of magnificent performance. Of course, hardly anyone in Canada has noticed.
Now, Australia is a politically stable democracy, has a solid financial system, a resource-based economy that is well positioned to sell to the emerging markets, and a currency that has appreciated strongly against the US dollar. Australians can’t understand why anyone would diversify globally, either: according to this report (pdf file), Aussies hold about 83% of their portfolios in domestic stocks, even though they make up about 4% of the world market. Sound familiar?
Would you put all of your equity holdings in Australian stocks? If not, why not? Why does that suggestion sound more ridiculous than putting all of your equity holdings in Canada? Because home bias is an incredibly powerful force.
Canada has enjoyed outstanding returns in recent years. But if you are a long-term investor, you need to ask yourself whether you truly believe that one country’s tiny, poorly diversified market will continue to outperform the rest of the world for decades to come.
(Tom Bradley of Steadyhand just wrote an interesting post on the subject that I think every Canadian should read.)
Dan, if 2008 wasn’t enough it looks like investors could get hit with another bubble- this time it could be bonds as interest rates begin to rise. China, the US, and some European countries are already feeling the effects of inflation on the prices of consumer goods. Stock markets are once again looking precariously high. How do you feel investors can best protect themselves in 2011? And putting the Couch Potato aside, where do you feel the best opportunities will be in the global economy?
Investors can protect themselves in 2011 the same way they should protect themselves in any other year: by building a broadly diversified portfolio that is exposed to a variety of risks, so it cannot be torpedoed by any one of them.
The coming year does not look good for bonds — but everyone said that last year, too, and they performed very well. And if we do end up having a correction in the equity markets, you are going to want those government bonds in your portfolio to act as a cushion.
The threat of inflation, rising interest rates, the potential for significant losses in the stock market — none of these risks are new. Neither are they predictable. Unless you have confidence in your ability to forecast the future, the only sensible approach is to diversify widely.
Once again Dan, thank you so much for taking the time for this interview – I know you spent a lot of time answering these questions. I hope readers enjoyed this interview as much as I did!
Always a pleasure to speak with you, Ninja. Keep up the great work on your blog.
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