It is said that the first step to achieving a goal is writing it down. The best plans are written, living documents that cover your goals and strategies for attaining them. If you just carry your goals in your head, they probably won’t get done. They are simply good intentions (with which “the road to Hell is paved”).
That may sound a bit intimidating. So the purpose of this lesson is to offer some suggestions and examples that you might use in creating your own investment plan.
Give your investment plan an inspiring name:
- Retirement Millionaire
- Free at Fifty-Five
- I’m Outta Here
This may sound trivial, but the idea is to inspire you with a name that suggests a goal that you know is achievable.
My wife and I own two dividend growth portfolios. They both have boring names: Dividend Growth Portfolio and Perpetual Dividend Portfolio. They were created several years ago. The names were inspiring to me then, but now they seem boring. If I start another one, it will have a snazzier name.
The first element in your investment plan is your goal. What do you want to accomplish? Your goal is the object of your investing – your desired result.
A goal may be “soft,” meaning non-specific. Or it may be precise and measurable.
In my public Dividend Growth Portfolio, I have both: A general directional objective plus a specific measurable benchmark.
The goal of my Dividend Growth Portfolio is to generate a steadily increasing stream of dividends paid by excellent, low-risk companies. The numerical target is for the portfolio to deliver 10 percent yield on cost within 10 years of inception. I am more interested in the ability of this portfolio to produce income than its sheer size.
My goal statement makes it clear that I want:
- A steadily increasing stream of income (not very specific)
- To invest in great companies (not defined, but this sets a quality target)
- To optimize income in preference to amassing sheer size (stating a clear hierarchy if the two goals come into conflict)
- To achieve a 10-by-10 goal: 10% yield on cost within 10 years (very specific benchmark)
Your goal may be broad, amounting to a vision. Examples of visions would be to retire by age 55 or to amass enough wealth that you will never run out. But if you state your goal too broadly, the lack of specificity may dilute how you think about achieving it.
If your goal is to retire by age 55, for example, add another line that nails down how much income you want to be receiving annually by that year.
That will be inspiring, and you may become excited about creating realistic strategies that will help you achieve that goal.
Most dividend growth investors love the idea of receiving “passive income” that they can live off of.
Don’t set goals that are not realistic and achievable.
If you earn $40,000 per year and have nothing saved, don’t set a goal of having $3 Million in 5 years. Subconsciously, you will know that is impossible, so you probably won’t even bother to get started.
Your strategies are plans, policies, and methods that you will use to achieve your objective. How will you get to where you want to go? Your strategies are your roadmap.
I don’t use my investment plan for to-do list items. I try to keep it at a pretty high level.
For example, I would not state in my investment plan, “Buy 25 shares of Johnson and Johnson.” Instead, I would lay out the principles and methods through which I would determine that purchasing JNJ (or any other stock) is a good idea.
Here are some categories that you probably ought to cover in your strategies. All of the indented quotes come from my actual investing plan, and they are just presented as examples.
Dividend growth stocks come with yields ranging from 0.1% to double-digits. Here is my own requirement:
Purchase stocks with yields (at time of purchase) of 2.7% or more.
I have experimented with lower yields, but in order to reach my own 10-by-10 goal, mathematically I need minimum initial yields of 2.7%.
Of course, many stocks have higher yields. Some investors set higher minimum requirements, such as 4% or even 5%. The higher you go, obviously, the fewer candidates there will be. There also may be more risk that the company will not be able to sustain it high payouts. So don’t go too high.
Dividend growth rate (DGR)
DGR goes hand-in-hand with yield, because it is the interaction of the two that determines your income and how it will grow.
Purchase stocks with a minimum DGR of 4% per year.
That’s my requirement. Investors usually measure DGR over the past 3 or 5 years.
Let’s look at the first few stocks (listed alphabetically) in David Fish’s Dividend Champions document.
Just at a glance, you can see that there are only 3 out of these 14 stocks that meet my two requirements for yield and DGR (using the 3-year column):
- ABB Limited has a yield of 3.5% and a 3-year DGR of 14%.
- Access Midstream Partners has a yield of 3.7% and a 3-year DGR of 107%.
- Admiral Group has a yield of 6.5% and a 3-year DGR of 15%.
None of the other stocks meet my minimums. That shows how your strategies point you in the right direction for achieving your goals.
Note that I am not saying that any one of those 3 stocks is a good pick. I am simply saying that none of the others meet even the first two simple requirements that I have.
In order to decide whether these three stocks would actually be good picks, I would need to analyze them further.
How you will analyze companies
Stock-picking for dividend growth investing requires more than just specifying your minimum yield and DGR. You will want to state here (or in an accompanying document) how you will analyze stocks for potential ownership.
Use the current Top 40 as my shopping list. The list may be modified during the
year by adding or dropping stocks after thorough analysis using the Easy-
The Top 40 refers to my annual eBook, Top 40 Dividend Growth Stocks. I use each year’s list as my shopping list for the remainder of the year. In rating stocks, I use a system called Easy-Rate that is described in my book.
Whether you use that or another system, you will want to do some fundamental analysis to identify the stocks that are worth owning to help you get to your goals.
Most investors maintain a shopping list. They update it from time to time as companies evolve and prices change.
Making a purchase involves a confluence of knowing in advance the companies that you want to own; waiting for Mr. Market to throw a sale so you can get them at good valuations; and of course having the cash available to invest when the other elements come together.
Having cash available means that you must save. It is an unavoidable truth that if you want financial independence in retirement, you will need to save money while you are working.
Obviously, how much you can save is personal to you. But set a goal and then “pay yourself first.” That means to set the savings aside before you blow it on stuff.
Can you save $500 per month? $200? Write that down. Whatever the amount may be, the time to start doing it is now. Because of compounding, the earlier you get started saving, the better.
Paying too much for even a great company is not a good way to invest. As discussed in DGI Lesson 11 on valuation, you want to buy companies when they are fairly priced, or better still when they are on sale.
Buy only stocks with “Fair” or better valuations.
In Lesson 11, I described in detail how I value stocks. In the end, I rate them on a valuation scale: Excellent; Good; Fair; Poor; and Bubble.
For my own investing, I only buy stocks at Fair valuations or better. This is a hard and fast rule for me. If I am tempted to stray, I look back at my investing plan to remind myself of what I am doing.
That is one of the great values of a written plan. When conditions are ambiguous, or your emotions are getting out of control, you can refer back to your plan and recall how you viewed the issue when you were thinking straight.
In DGI Lesson 10 Part I and Part II, we reviewed the two ways to reinvest dividends: By dripping them back into the companies that distribute them, or by accumulating them and then making targeted purchases.
Reinvest dividends, but not automatically back into the company that issued them. Rather, when the cash accumulates to $1000, select the best candidate at that time to buy.
Over the years, you will reinvest lots of dividends. The total you reinvest may well exceed the amount of “new cash” that you use to establish your portfolio in the first place. Just because the dividends arrive in small amounts should not lead you to be careless with how you reinvest them.
Of course, once you retire, you will probably stop reinvesting, or you will only reinvest part of what you receive and spend the rest. That will be because Happy Time has arrived: You can live off your dividends and not have to work at a job any more unless you want to!
Number of stocks
Different investors have portfolios of different sizes. How many stocks you want to own is a function of how many companies you can keep track of; how much income you want to have at risk from any one company; whether you want a “core and satellite” type of portfolio; and so on.
Shoot for an eventual total of 20 to 25 stocks in the portfolio. Aim for well-roundedness in the portfolio. Diversify across sectors, industries, geographies, and different ranges of yields and growth rates.
My target of 20-25 companies would be too concentrated for some investors. I know many dividend growth investors that want at least 50, or even 100, companies in their portfolio. They see the higher number of positions as a risk-control tool, spreading out their bets.
The math is easy: If you own 50 companies in equal amounts, only 2% of your portfolio is at risk from any one of them. If the number of companies is 33, the amount at risk rises to 3% for each one.
So this is not a math question. How many companies to own is a personal question. Base your answer on your own comfort level with a larger or smaller number of companies.
Connected to the question of how many stocks to own is how much weight each carries in your portfolio.
Some investors rebalance regularly, some never. I have seen research supporting frequent rebalancing, occasional rebalancing, and no rebalancing.
Say you own 20 stocks, and your target is to own them about equally, meaning that each position represents 5% of your portfolio. There are several ways to look at a rebalancing policy:
- You could rebalance by the calendar, say every 6 months or 12 months. If you do this, be aware that you will incur trading costs to make small adjustments. You probably want to build in some leeway in the equal-weight goal. For example, only adjust if a position gets beyond 6% or falls under 4% of your portfolio.
- You could rebalance only when positions get way out of whack. Again, you could accept any position that falls within the 4% – 6% range, and make adjustments only when a position gets outside that range.
Position sizes can wander as the result of price changes in the market. Also, if you drip dividends, some positions will grow faster than others, because they will be receiving more dividend reinvestments. Those will eventually become overweighted.
Hold no more than 15 percent of the portfolio’s value in a single stock. Rebalance the portfolio when necessary to redress excessive size that may have developed in a particular holding. There is no minimum size requirement.
Aside from the maximum size limit, be agnostic on position sizing. Initially, investing an equal initial amount in each stock is fine. Adjustments in proportionate sizes will occur as prices change, dividends are reinvested, and sales are made in the normal maintenance of the portfolio.
As you can see from my own guidelines, I do not rebalance regularly. My maximum position size of 15% is more than most investors would find prudent or tolerable. It works for me, although I do sometimes consider dropping the maximum to 10% or less.
Even without regular rebalancing, each semi-annual Portfolio Review allows me the opportunity to consider selling or adjusting the size of any stock.
This is the last category that I want to cover. Most investors find it harder to decide when to sell than what and when to buy.
The urge to sell is often emotional, especially when the market is falling. Human nature induces many investors to flee to cash, but that is often a self-defeating action. You are not running from a sabre-tooth tiger. You are dealing with the market. Do it rationally.
Investigate and seriously consider selling any stock for these reasons:
(1) It cuts, freezes, or suspends its dividend.
(2) It bubbles or becomes seriously overvalued.
(3) You receive news of significant changes impacting the company.
(4) It is going to be acquired.
(5) It announces plans to split itself or spin off a separate company.
(6) Its current yield rises above 9 percent or drops below 2.5 percent.
(7) Its size increases beyond 15 percent of the portfolio.
These are my selling guidelines. They are mostly self-explanatory.
The main thing I want to emphasize about them is that these are guidelines, not hard-and-fast rules. The language “seriously consider selling” is carefully chosen. Even if a stock freezes its dividend, I want the flexibility not to sell it. Maybe the company has a good reason, and it is clear that dividend increases will resume shortly.
Guidelines (2), (6), and (7) interact. If a stock’s market price shoots way up, the stock’s valuation may deteriorate (2). Since yield = dividend / price, its yield may fall way down (6). And the price increase may cause its weight in the portfolio to go out of bounds (7).
In my Dividend Growth Portfolio, Johnson & Johnson is an example of a stock I am watching.
JNJ has had a great price runup over the past two years. As a result, its valuation has turned disadvantageous (2 stars from Morningstar), its yield has dropped nearly to my minimum for holding (2.6%), and its relative size in my portfolio sits at more than 13%.
What I might do is trim JNJ. I have a sizable profit in it – the first shares I purchased in 2011 are up over 80%. I could sell some shares, maybe take its size down to 9% or 10% of the portfolio. That would give me cash to invest in a different stock that may have a better yield and better valuation.
I would only do that if I had a great candidate to replace it. JNJ is a terrific dividend growth stock, with annual dividend increases that have stretched for 52 years, averaging about 7% per year for the past 5 years. I would not sell it lightly.
Dave Van Knapp
Author of Top 40 Dividend Growth Stocks