Personal Finance
How Religion Can Make You a Smarter and Richer Investor
When you’re on fire with the hope of striking it right on some investment, remember to consider not just how much you will make if you are right but how much you will lose if you are wrong.
In what’s known as “Pascal’s Wager,” the mathematician and theologian Blaise Pascal provided a model for how to think about this problem.
Now I’m actually not a very religious person, but I’ve always liked the following example.
Since God’s existence is a matter of faith, not scientific proof, how should you live? Let’s say you gamble that God exists, so you lead a virtuous life – but it turns out there is no God. You miss enjoying a few sins while you are alive, but that’s all your gamble costs you. Now let’s say you gamble that there is no God and sin your way through life without a qualm – and it turns out that God does exist. The payoff on this gamble is a few decades of cheap thrills – then an eternity burning in Hell.
Pascal’s Wager shows that whether you should take a risk depends not just on the probability that you are right but also on the consequences if you are wrong.
Moral of the story? To make reliably good decisions, you must always weight how right you think you are against how sorry you will be if you turn out to be mistaken.
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Dividend Investing: The Rich Man’s Guide to Making Money in Your Sleep
When markets get iffy, dividends look spiffy. (That was a terrible rhyme)
One of the reasons I started this blog was to explore different sources of passive income. And one of the best and most popular methods to earn a passive income is through dividend investing.
What is Dividend Investing
A dividend is a sum of money paid regularly (typically quarterly) by a company to its shareholders out of its profits. These dividends provide investors with a steady income stream that is not dependent on market fluctuations. The money represents spendable cash that can either be reinvested or used.
If the dividends are reinvested, overall investments will increase at a compounded rate. The individual will own more shares that earn dividends, which will increase the total income stream. At the same time, stock values are known to historically increase, so the shares that are purchased with the dividend money will also increase. This adds to the overall investment value, making it a double win for any investor.
In addition, stocks that pay dividends are usually less volatile than those that do not. The fact that the stock has reliable dividend returns presents less risk to an investor. This is especially important when the market is declining because investors will not be able to get needed returns from price appreciation. Investors tend to buy dividend stocks during this time, an action that further stabilizes the stock price and allows it to fall less than the equity market in general.
Case Study: Dividend Income Portfolio
While the explanation above paints quite the rosy picture for dividend investing, I’m looking for more concrete evidence that dividend investing can be an effective passive income stream. So I decided to run a little test.
The Goal: To measure how well a dividend income portfolio can perform, using compounded annual rate of return as a metric.
The Experiment: Starting with an imaginary balance of $100,000, I’m picking 10 dividend stocks recommended by one of my favorite investing blogs www.jubakpicks.com. The stocks will be equally weighted with $10,000 invested in each.
The Criteria: Stocks are selected under the condition that they will appreciate in price and pay more in income than the current yield on the 10-year U.S. Treasury. That’s a moving target, of course, but at the time of this post, the 10-year Treasury pays 3.22%
Disclaimer: I’m backdating my data to get a measurement of performance for the past 20 months. Back in 2010, the environment was very different. A lot of stocks were still selling at depressed prices and offering exceptionally juicy dividend yields. The stocks listed here are for reference only and not meant to be taken as investment advice.
Dividend Income Portfolio
Dividend Income Return
One way is to determine ROI is to look at how much cash the portfolio throws off. Many investors don’t reinvest this cash but instead use it as income or to supplement income. From my starting point of October 2009, this portfolio of 10 stocks, equally weighted, and with $10,000 invested in each one for a total of $100,000 has thrown off $30,870 in cash. That’s a 30.87% in approximately 20 months. If you convert that to a compounded annual rate of return it comes out to 17.5%.
Again, it’s important to keep in mind that you’re looking at a stock market that has rallied pretty much non-stop for the last year so many of the hefty yields of yesterday have been turned into much more modest payouts.
A second way to look at the performance of a dividend income fund is to see what happened to the principal. Did I lose a good part or any of my original $100,000 in order to get that kind of return. In this case, with no dividends reinvested – I’m taking all the money out to spend on women and booze – and simply rolling over the money from each position into a new position, the original $100,000 has grown to $151,451 as of May 3.
However, you can’t simply add those two numbers together and say that’s been the return on the portfolio. For one thing, the rate of return changes as your principal changes, so future dividend earnings will reflect this. What this does prove to me is that if implemented correctly, dividend investing can be a great passive income strategy. With dividend income, you reap the benefit of having your overall portfolio value grow, increasing the net value of your assets, while at the same time earning a very respectable income.
Best of all maintaining this portfolio requires minimal work. You can invest the time up front to research for bargain companies, or in my case piggyback off of the research of a successful investor. After that you only need to follow-up and make periodic checkups on the overall health of the companies you’ve invested in.
Even today, based on the sector investing philosophy I’ve shared before, I think you can find better than 10-year Treasury yields at risk that is less than the market perception. Currently stocks in the energy and industrial sectors have lagged through all of 2010 but it looks like the market and economic cycles have turned in a way that give these stocks a good chance to appreciate in 2011. Higher yields always come with more risk. But you can minimize that extra risk with good stock picking.
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Do you use dividend investing to diversify your passive income portfolio?
Sector Investing
My favorite lazyman’s approach for long term investing is sector investing. Simply because it takes advantage of historical trends, requiring minimal effort on my part, and allows me to capitalize on market shifts.
Notes for My Personal Reference
Solid data stretching back to 1945 show that certain industries and sectors outperform during specific stages of any economic recovery.
The best work on this subject comes from Sam Stovall, the chief investment strategist for Standard & Poor’s Equity Research. His 1996 book, “Sector Investing,” is still the best resource on the subject.
Stovall divides the economic cycle into four stages:
- Early recession. You should remember this stage vividly. Consumer sentiment ranges from fear to terror, industrial production plunges, interest rates peak and then start to fall, and unemployment begins to rise rapidly. Sectors that have done well — relatively, at least — during this stage include services, near the beginning; utilities; and, near the end of the stage, cyclicals and transports.
- Full recession. Gross domestic product tumbles, interest rates keep falling, and unemployment rises. Sectors that do best during this stage, historically, have been cyclicals and transports, at the beginning of the stage; technology; and, near the end, industrials.
- Early recovery. Consumer sentiment improves, industrial production turns up, interest rates hit bottom, and unemployment peaks and starts to move lower. Sectors that do best are usually industrials, near the beginning of the stage; basic materials; and, near the end, energy.
- Late recovery. Interest rates rise as the central bank tries to control inflation, consumer sentiment heads down, and industrial production is flat. Sectors that have done well in this stage include energy and, near the end of the stage, consumer staples and services.
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