One of the reasons so many people have such a difficult time with their finances is because they come into the process with faulty assumptions. There are unrealistic and ill-informed expectations that set people back from the start.
Here are some of the faulty assumptions I see over and over again from both financial firms and investors:
Outperformance should be the number one goal. Many investors start out with the assumption that outperforming the market is their sole mission. Fund managers perpetuate this myth by making promises that the majority of them have no business making. Most investors have a hard enough time earning the actual performance in their own funds, let alone trying to outperform the market.
A stock with a 3-4% dividend yield is a “safe” investment. Investors have a difficult time separating income or yield from total return. A higher dividend yield is not going to shelter you from losses or offer more stable returns simply because of the existence of a stated income payment.
Hedging is the same thing as diversification. A portfolio full of hedges is not necessarily diversified. People have a habit of assuming that placing a number of hedges in their portfolio will protect them from market risk. In reality, hedges can actually introduce unintended or unnecessary risks when not used correctly.
Asset allocation needs to be perfectly optimized. Every advisor or investment firm assumes that they have the best asset allocation for their clients. A dirty little secret in the industry is that most allocations with similar stock market exposure will get you to roughly the same place (before fees). The ability to stick with a stated allocation matters much more than the allocation itself in most cases.
“Taking money off the table” is a legitimate investment strategy. Investors love to ask this question about certain asset classes, sectors, strategies or individual securities. I’ve never seen a successful investor who incorporates ‘taking money off the table’ into their process. If you have to ask this type of question it shows that you don’t have a plan or process in the first place. Even if you’re able to successfully sell at the right time, it’s highly unlikely that using a guessing game will allow you to buy back in when you need to.
Insurance is an investment. Insurance is a way to protect your wealth (or your family) from severe risks. Investing is about creating wealth. Both can be helpful, but they should not be confused. Insurance is generally not a legitimate form of investing or building wealth.
I’ll start saving later. There will always be reasons to put off saving until the future. There will rarely be a perfect or comfortable time to start saving money. It’s never going to happen if you don’t make it a habit.
Investing is the sure path to riches. Your investing skills won’t matter if you’re constantly in debt, don’t save enough money or can’t get your personal finances in order. I’ve seen plenty of finance people who have very successful careers but are terrible with their own finances. All the market knowledge in the world won’t help if you don’t understand the basics of personal finance.
Surely, everyone else is an idiot with their finances, but not me. This one has to be true, right?
Further Reading:
Personal Finances > Portfolio Management
Here’s the stuff I’ve been reading lately:
- Your dangerously selective memory (Bason)
- 5 things smart beta can’t do for you (TRB)
- The case for and against strong future returns (EconomPic)
- To be great you must first learn to be good (TRB)
- 8 more lessons from Judd Apatow (Waiter’s Pad)
- Why momentum works (EightAteEight)
- Is happiness through wealth a zero sum game? (Monevator)
- Why do American Funds have so many share classes? (Gordian)
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“A stock with a 3-4% dividend yield is a “safe” investment”
No offense but this statement itself from the article is either a straw man argument or a faulty assumption in itself.
You have no idea whether those who you are accusing of faulty thinking did their homework before determining that a company providing a 3% – 4% yield is a “safe investment” (plus we should be talking about a portfolio of companies, not a single company). With your statement you are implying that an investor blindly chases yield, and hasn’t done their homework (meaning they bought something without understanding it). If that’s what you meant, then your article would have been strengthened by saying that outright.
I would argue that a portfolio of companies paying a dependable dividend of 3% – 4% that grows with inflation could be more dependable than a portfolio of companies that yield nothing and your return is dependent mostly of capital gains. A retiree is interested in not outliving their money.
I enjoyed the other points outlined in the article.
I have no problem with dividend investing, but the point I think he was trying to make was that dividends=safety is not a correct assumption. It’s total return, and many, many investors don’t really understand that statement. Whether corporate profit is returned through dividends, returned through share buybacks, or invested in hopefully profitable growth ventures/avenues for the company, it’s the total return over long periods of time that matters the most.
Agreed.
Not only that, but many popular financial columns aimed at retail investors will cite stocks with deeply declined share prices that now have attractive dividend yields. The thesis is buy this stock and earn this high dividend while you wait out the cycle and the stock rebounds, so it’s a win-win. While this completely ignores the fundamental reasons the shares have declined, many rookie investors don’t understand that the dividend is not safe in these investments, a company in such distress may, and probably should, cut it’s dividend to boost capital. It entices them to buy shares of a troubled company and shortly after they may see that handsome dividend be reduced or eliminated, so can become a lose-lose.
Anything that is not contractual is not safe, dividends included. As you say, if you ignore the fundamental facts about the company (and you are putting all eggs in that basket), you are asking for trouble.
Of course, it’s a very general statement, but one that I see quite often. Think about people investing in bank stocks in 07-08. Or MLPs more recently. I think there are just some investors out there who don’t consider alternative risks beyond yield and lose their focus beyond that number.
If I had a dollar for every time I had to explain to a client the difference between current return and total return, or the relationship between risk and reward, I’d have a lot more dollars to support me in retirement. Unfortunately far too many clients (at least in my experience) chase current yield or past returns without having any idea what the risks involved might be. A 3-4% current yield is not in and of itself a bad thing, but the blind assumption that it’s a “safe” investment without some idea of how these funds are being generated, is.
Yup and that chase for yield seems to really be ramping up in the interest rate environment.
When I read “taking money off the table” I read: selling positions for cash because you believe the price is favorable. When I read “sufficient liquidity to…take advantage of opportunities from the brutal bear market” I read: having cash to buy when prices are favorable. Both are essentially “timing the market” actions, yet the former is framed as bad, the latter as good.
What am I missing?
I think it all comes down to having a plan of attack with that cash. Far too many people fail to realize that this strategy takes two decisions. Cash becomes something of a security blanket when stocks are falling and it can be difficult to buy back in (which happened to many people the past few years).
I agree that it can be a very intelligent form of investing, but my sense is most average investors do so without a detailed plan in place to guide their actions.
In my estimation, the people’s biases related to cash are at the root of the issue that is the vast chasm between money-weighted and time-weighted returns in mutual funds (where fund performance is x percent and investor performance is x less than x minus fees).
If one views cash as an investment position (which in my view it is wrong), one could consider it safe only for the shortest of time; it is excessively risky over the long term.
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I will go on record to say a dividend yield or distribution yield, consistently, around 3% is pretty “safe”.
Example #1 – XIU ETF, the biggest 60-stocks in Canada. Yield as of Dec. 4 = 3%
Example #2 = VYM ETF, owns 400+ of the biggest dividend payers in North America. Yield as of Dec. 4 = 3.1%.
Those could be two set and forget funds.
Totally agree though: “A higher dividend yield is not going to shelter you from losses or offer more stable returns simply because of the existence of a stated income payment.”
Dividends and capital gains are usually two sides of a coin.
Mark
Good point. They can go hand in hand, but I think that many investors assume for some reason that dividends will save them from principal losses too.