From the June 2011 issue of Investment Advisor • Subscribe!

Value, Dividends and Risk Matter in Retirement

Investors need a ‘responsive system’ to improve return and build capital

A historic 10-year bear market has left investors less wealthy, with many wondering if they can ever actually win at investing. We believe conventional ideas about investing need to be discarded if there is any hope of turning the tide.

Passive buy and hold allocation strategies can hand investors severe losses as market prices move sharply lower. As investor survival instincts kick in, these losses can cause them to “buy and fold” as they move to protect dwindling capital. This may cause them to sit on the sidelines for several years until markets have been steadily rallying. Investing late in the game often makes investors channel assets into the hottest growth stocks or sectors in an effort to play catch up. Instead of buying low, they buy high and set themselves up for additional losses as overvalued markets correct.

Value Matters
One of the basic tenets to successful investing is to buy low and sell high, yet investors seem to do just the opposite. An easy way to improve performance is to only buy stocks when they are cheap. If you can’t find stocks to “buy low,” then keep your money in cash until you can.  

We suggest focusing on cash flow from operations to signal healthy profits and a company’s ability to cover debt, while continuing to pay dividends. Liquid assets plus excess cash flow need to allow the company to pay any short-term debt coming due. Growth trends in earnings and revenue should be positive for the most recent quarter and for the last 12 months. Dividend payout ratios should show the board’s commitment to supporting and increasing dividends without compromising its ability to reinvest a portion of earnings to drive growth. Try to buy stocks when they are trading in the bottom half of their normal price trading range, and never buy a stock when its price is declining.

Dividends Matter
Dividends provide a systematic source of return every quarter. Cash flow is an extremely important return component in market cycles that don’t favor the return from price appreciation. Dividend-paying stocks have historically increased dividend income at a faster rate than inflation as measured by CPI. The combination of increasing income that can be reinvested to promote compounding and price appreciation can help reliably grow investment capital.
A hypothetical $10,000 investment at the beginning of 1945 in the Dow Jones Industrial Average Index would have grown to $767,000 from price appreciation. If you had reinvested dividends to promote compounding and dollar cost averaging, the value would have increased to more than $9.3 million. According to Thomson Reuters Baseline, DJIA companies have increased dividends by 9.95% per year over the past five years through 2010. From 1945 to 2010, DJIA companies increasing dividends have outpaced the increase in CPI by more than 3:1.

Risk Matters
By focusing on the income received quarterly, investors may even be able to stay invested in declining market cycles. In volatile markets, additional risk management techniques are required to reduce volatility and loss. The objective of our risk management plan is to participate in up-market cycles while rationally moving from a fully invested position to raising cash as markets decline. Market history indicates that limiting loss of capital is far more important than attempting to get the highest return.

We suggest advisors use goals and stops to protect capital and to harvest gains. A risk management system can also provide an important secondary benefit by helping to take the emotion out of the investment decision, which can improve results. We believe a responsive system to avoid big losses can help improve return and build capital more reliably than traditional passive approaches.    

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