When it comes to dividend-growth investing, we tend to place a lot of focus on identifying the best actions to take—the never-ending quest for the silver bullet or magic formula to success. However, as with so many things in life, investing success is as much about avoiding bad actions and/or behaviors as it is about having to take the perfect ones. The reality is that there is a plethora of potential paths to long-term investing success—but a few devilishly veiled traps along the way that can derail any investor. In this article, we will examine four perilous pitfalls you should seek to avoid when engaging in dividend-growth investing.
These pitfalls are not exclusive to new investors—they are germane to all of us. Anyone can unknowingly become ensnared in one of these traps (I’ve experienced my fair share of encounters over the years). I encourage you to routinely perform an honest self-examination to ensure you are not unwittingly falling prey to one of these four investing pitfalls. I have personally included this as a step in my investing plan—a part of my quarterly review process.
In today’s article, we’ll look at these four DGI pitfalls you should avoid at all cost:
The first pitfall to avoid is investing without a plan or strategy. While this may seem obvious, I am always surprised at how many new investors jump into the game before they ever develop one! While we can all appreciate their display of unbridled passion and enthusiasm, it is that very emotion that will leave your investing ship smashed on the rocky shore of the great ocean known as the market.
However, as I noted earlier, it is not just new investors that need to be wary of this insidious trap—it is frighteningly easy for even the most veteran of investors to slowly go astray from their plan without realizing it.
Your investing plan is your map. A good one will get you safely and efficiently to your desired destination. It should address, at the very least, these critical components:
As noted earlier, there are lots of perfectly effective ways to invest—even within dividend-growth investing there is a wide spectrum of approaches. You need to narrow your focus and identify what your precise process will be—so you can understand it and stick with it over the long run. I highly encourage you to read my article Dividend-Growth Investing Success Is All about the Process to learn more about the importance of process in shaping your investing success.
Failing to have a well-defined investing plan can derail your pursuit of success by:
These potential landmines can cause you to develop the wrong mindset—making it hard for you to stay in the game. Ultimately, they will lead to reduced gains… or even losses. I cannot stress how important mindset is for achieving long-term dividend-growth investing success. Your plan is the framework that shapes and guides your investing mindset—don’t leave home without it! To learn more about developing the right DGI mindset, I recommend reading my articles Paradigm Shift: Dividend vs. Growth Investing Mindset and 6 Ways to Win the Dividend-Growth Investing Mental Game.
Takeaway #1 is have a solid investing plan. Plan your investments and invest according to your plan!
The second dividend-growth investing pitfall to avoid is having inadequate diversification in your portfolio.
One way to avoid this pitfall is by using ETFs and funds. However, I would argue that this approach swings the pendulum way to far the other direction—creating over diversification. And, this approach is also not devoid of its own pitfalls—read my article 8 Not So Obvious Downsides to Index-Fund Investing.
If you are willing to invest a little time and effort, building a portfolio of individual dividend-growth stocks has tremendous advantages. Unfortunately, it can open you up to what is known as idiosyncratic risk—or single-stock risk (volatility).
I won’t dive into the details—check out my article Idiosyncratic Risk: Is Your Portfolio Really Protected? for a closer look—but the reality is that any given stock can exhibit extreme volatility. The market is full of historical examples of this risk. For example, look no further than BP or GE. These two companies also demonstrate that this risk is inherent in all companies—even the large ones.
To mitigate this idiosyncratic risk, you should ensure that your portfolio is properly diversified—not concentrated in a few assets. While there is no perfect answer to how much diversification is appropriate (and more does not necessarily equal better), most investors—including myself—would recommend a minimum of 15 to 20 stocks in your portfolio. Obviously, the less related these stocks are, the better (e.g., different industries/sectors, market caps, geographical focus, etc.).
While proper diversification cannot fully protect you against market risk, it can (a) protect you against idiosyncratic risk and (b) potentially reduce the impact of market risk.
Takeaway #2 is ensure you employ adequate diversification in your portfolio.
The third pitfall to avoid when dividend-growth investing is falling prey to herding.
Simply put, herding is following the crowd. You chase the “hot” stocks and market “noise”—acting on emotion and momentum. It’s that “I’ve got to get on the bandwagon” (FOMO) approach that inevitably leads to buying high and panic selling low—the exact opposite of what you need to do to achieve success.
Herd mentality pivots between points of irrational exuberance and irrational capitulation. Never tell yourself, “This many people can’t be wrong!” Not only can the herd be wrong… it almost always is!
Success in value or dividend investing (including DGI), requires a contrarian mindset. You should be fearful when others are greedy and greedy when others are fearful. This requires a systematic approach—buoyed by intestinal fortitude that is predicated on an understanding of your process.
For a long-term investor, time in the market always trumps market timing. A systematic process enables you to achieve that and a contrarian mindset enables you to capitalize on value opportunities that provide greater margins of safety and long-run returns. By doing so, you capitalize on the short-term irrationality of the herd through time arbitrage, while avoiding their agonizing fate.
Takeaway #3: Investing is an individual (not team) sport—ignore the herd! Do your own homework, understand your contrarian process, and stick with it with conviction and without emotion.
The final pitfall to avoid as a dividend-growth investor is anchoring.
Simply put, anchoring is tying an action or investing decision to irrelevant data or information. Specifically, it refers to historical data or information that is no longer valid.
We live in a dynamic and chaotic world—one that is in constant flux. Information is constantly changing. What was relevant yesterday, last week, last quarter, or last year may not be equally relevant today. As such, we must constantly update—and adjust where and when necessary—our analysis and investing theses.
When we fail to do this, we risk falling into the trap of anchoring. We can anchor to anything; however, in investing, we typically succumb to anchoring to:
First, we anchor to price points when we say, “I’ll get out when the price gets back to $X.XX (what I paid for it)” or “The price of XYZ can’t go any lower.” What we paid for a stock in the past is irrelevant and price can always go lower—or higher. Price is a reflection of the aggregate market opinion—one based on all available information today. Circumstances change and a given stock may never get back to a given price.
This type of anchoring can lead to the deadly buy-the-dip tactic. There is nothing wrong with lowering your cost basis when the current facts support your value proposition. However, when they don’t and we still keep buying the dip based on the irrational expectation that the stock can’t go any lower or will eventually get back to a target price, it can spell disaster for us. This happened to a lot of long-term investors in GE who anchored to irrelevant facts and resisted the need to change their thesis!
Second, we anchor to index performance when we exit positions because the SPY (or other index) plunged—even if our holdings have nothing to do with why the index did what it did. The performance of an index may be irrelevant to the performance of our holdings—don’t anchor to it.
Third, we anchor to valuations when we buy a stock because we feel it is at a big discount to past valuations. For example, stock XYZ typically trades at a PE of 21 and now it’s at a 16—so it must be a great buy. Past valuation (like price) is irrelevant to what the intrinsic value of a stock is today. It may be a great deal… but there may be new information or data that warrants a lower valuation today—don’t anchor to irrelevant valuation. This is how we fall prey to value traps!
Finally, we anchor to previous analysis and/or an investing thesis when we base valuations on irrelevant fundamental data. For example, company XYZ may have exhibited 10% growth over the past ten years. However, a discounted cash flow (DCF) valuation based on this growth over the next ten years may be terribly flawed if new data suggests the company will only grow earnings at 4% over that time period. Similarly, debt leverage can change quickly with new information regarding debt issuances. You have to make your investing decisions based on the current information you have—don’t anchor to irrelevant data and information!
It is worth noting that dividend-growth investors are particularly susceptible to anchoring to dividend information. You hear it all the time: look for a long and consistent pattern of dividend growth. I can’t emphasize enough how dangerous this can be… past performance is not indicative of future performance. Just because a company has raised dividends over the past X number of years does not mean it can’t reduce or cut its dividend in the future if its fundamentals (or broader economic conditions) change. Don’t anchor to irrelevant data. Make sure the current fundamentals support your conclusion!
Takeaway #4: Don’t anchor. Be forward-looking… not investing through your rearview mirror. Always update your analysis and adjust your investing thesis where warranted! Finally, if your thesis changes, don’t be afraid to cut your losses—don’t anchor to a past price… riding the price down as you cling to the irrational hope that it will return to where it was in the past! Move on… there are always other fish with “value” in the market sea to redeploy that capital into.
There is no silver bullet, magic formula, or one “best” way to achieve success in investing. There is an infinite number of ways to get there. However, there are some “wrong” ways—or perilous pitfalls—you should avoid at all cost. These insidious traps can derail your investing pursuits before you realize what hit you!
By constantly being on the lookout for these hidden snares, you can keep yourself on the path to long-term investing success.
If you’re looking for more insights into dividend-growth investing, then you’re in the right place!
At Wicked Capital, we focus exclusively on helping others become as successful as possible with dividend-growth investing and we hope you’ll continue to return to our site to learn, grow, sharpen your skills, and find effective and positive ideas and motivation!
Soak it all in, take and use what you want, modify it to fit your unique situation, and keep building that DGI portfolio with a solid process and winning mindset!
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