Unconventional wisdom: Are dividends the answers?
As investors toil in complexity the obvious solution may be the right one.
Conventional wisdom is a byproduct of groupthink that presents solutions good enough for the average person while simultaneously not being right for any individual. You follow it at your peril. Each Monday I will challenge the investing norms that just may be holding you back from living the life you want.
Unconventional wisdom: Are dividends the answers?
“The market is there to serve you rather than instruct you.”
- Warren Buffett
Inhabitants of the English industrial city of Birmingham were not held in high esteem by their countrymen in the 19th century. The slang term Birmingham screwdriver referred to a hammer. It was intended to evoke a lack of sophistication and a perceived tendency for residents of Birmingham to use brute force to solve every problem.
Perhaps a more enlightened treatment of the same concept was evoked by American Psychologist Abraham Maslow who coined the phrase, “if all you have is a hammer, everything looks like a nail.”
What became known as Maslow’s Hammer is a heuristic. A heuristic can be defined in different ways. A less generous definition is encapsulated in the disparaging term ‘Birmingham screwdriver’ – an ignorant and clumsy approach at a solution to a problem. A more generous interpretation of heuristic is a pragmatic approach to problem solving where effectiveness outweighs a perceived lack of sophistication.
In the spirit of Maslow and the maligned residents of Birmingham I will use my chosen hammer of dividends to take on some of the biggest challenges in personal finance. You can decide if I’m being pragmatic or simply ignorant and clumsy.
Using your assets to improve your life
We live in a country where most wealth is held within the depreciating walls of people’s homes. There are good and bad things about this. And there are perfectly rational reasons we find ourselves in this situation. There is no capital gains tax on the primary place of residence and their value is not included in the means test for the age pension.
For too many people this means that their largest asset does not meaningfully contribute to their life. I know that is a controversial statement. A home provides a place to live. A fully paid off home reduces the largest monthly expense in most people’s budget. Owning your home provides security.
Yet for many people the paper gains on housing provide the illusion of wealth without the commensurate increase in living standards one would expect. There are ways to extract wealth from a home like a reverse mortgage or downsizing. For many Australians they remain a last resort.
Buying a house may be the best way to increase wealth. But that isn’t all that matters. There is productive wealth that makes life better and provides options and freedom. And there is unproductive wealth that sits there and acts as an anchor while sucking up cash for maintenance. There is a big difference.
Unsurprisingly to those that know me I think buying shares that pay dividends is the epidemy of productive capital. The beauty of a dividend and any associated franking credits is that assets can contribute to your life without having to be sold.
Dividends give you options. You can choose to reinvest them, accumulate them in cash or spend them. Building passive income is the pathway to freedom.
Making retirement a little more predictable
What makes financial decisions challenging is the unknowns. We save for a rainy day without knowing if or when it will come. We invest for a better future without knowing the returns we will receive.
The quantity and magnitude of the unknowns associated with retirement make it one of the biggest financial challenges. To try and bring a measure of certainty into this great leap into the unknown we search for the perfect withdrawal rate. The ideal balance between the security of never running out of money and the spending to support a great retirement.
One way to ensure you never run out of money is to live off passive income. Passive income can mitigate sequencing risk and longevity risk – the two biggest threats to retirement. Passive income provides a retiree with the options of riding out bear markets and retaining the option of choosing when to sell.
I constantly hear from members of the Morningstar community who have retired off passive income and the peace of mind this provides. They may have discovered the secret to a secure and anxiety free retirement.
Finding the right shares to buy
Warren Buffett likes to talk about his circle of competence. Most investors nod along respectfully and ignore him. Who needs a circle of competence when you read two paragraphs on Facebook about a biotech company in stage one trials.
Buffett’s point is that being an investor – even a great investor – doesn’t mean being an expert on every company. You don’t even need to be an expert on that many companies. The great man himself said, “You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.”
Different investors will have different circles of competence. Personally, I gravitate towards companies and industries that are easier to evaluate and generally sell non-discretionary products and services to end consumers. There tends to be a high degree of overlap between dividend paying companies and those that are easier to evaluate.
This is not an absolute rule. But dividend payers are typically larger and more mature companies. That makes their future outcomes more predictable. That predictability makes it easier to figure out if valuations are wildly out of line.
Nobel prize winning economists Fama and French in a 1988 paper found that dividend yields are predictive of share returns – crucially the predictive power is weak over the short-term but significantly predictive over the long-term.
Common sense and academic studies like the one from Fama and French indicate that income investing is easier than other forms of investing. That doesn’t mean you aren’t giving anything up. More predictable outcomes means there is a less of a chance of both poor outcomes on the downside and outsized positive outcomes. That is a trade-off I’m personally willing to make. Each investor will have to come up with their own answer.
Final thoughts
In the town in Connecticut where I spent my high school years a group of Nobel laureates started a hedge fund called Long Term Capital Management. They knew everything there was to know about investing.
In the spirit of Maslow’s hammer they used what they knew to create an incredibly complex investment strategy using a good deal of leverage – because leverage amplifies returns.
In most situations Long Term Capital Management would have been a sparkling success. But things got derailed when the Asian Financial Crisis in 1997 morphed in the 1998 Russian Financial Crisis and the hedge fund collapsed under the weight of complexity.
As I learned more about investing I was tempted to go down a more complex path. I dabbled in options. I bought some speculative shares.
None of those moves were disastrous but it occurred to me that I was making things harder just for the sake of it. I was using options just because I learned how an option works. I was confusing complexity with competency.
I’ve since changed course. And to end on a terrible pun – I’ve learned that in investing simplicity often pays dividends.
Comments? Email me at mark.lamonica1@morningstar.com
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What i’ve been eating
The word bibimbap translates to ‘mixing cooked rice’ in Korean. Rice is a constant but all manner of vegetables, meat and fish can be added. A raw egg is generally placed on top and gochujang the spicy Korean chilli paste is provided to mix in. The number five plays a big role in Bibimbap. The dish is meant to incorporate the five flavours of a balanced meal including salty, sweet, hot, sour and bitter. It is also mean to represent Obangsaek which are the five colours of Korean cuisine: red, blue, yellow, white and black. The dolsot version of bibimbap is served in a heated stone pot which not only gets the rice crispy but also causes everyone in the restaurant to look at you – a win. Below is the bibimbap dolsot at the lovely family run SANG in Surry Hills.
