Investment Moats

A Jedi Mind Trick to Stay Invested with Bear Looming

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The Markets have ran for 4 years plus which is typical average for a bull. What usually happens is a 1-2.5 years of bear market.

With that I get asked quite often where the market is going and when will the bear come. I am no fortune teller and market predictions are usually murky at best, whether you are using economics, politics or technical analysis to reason.

Young investor with a long term horizon

Naturally, the group that asked most often are the young folks around my age. We are afraid of losing our capital.

The thing that works for us is that we probably still have 20-30 years of investing horizon more.

If you are a young person that grew their portfolio with a cost of $40k, losing 60% of your capital in a 1-2.5 years bear could look rather devastating.

The importance is your funding to your Wealth Building

I repeated a few times that as a young person, planning your budget and paying yourself first is important because having a regular source of funding to your investment war chest  would enable  you to live past this.

Should you be funding your wealth building with $1000/mth and $2000 of your bonus, yearly you would have contributed $14000.

If a 2.5 year bear comes along

If  a long drawn bear comes along, your yearly $14k funding would be invested at a lower cost.

You would have picked up bargains that you were not able to pick up in your original $40k

That is why for an investor with this profile, the are in a unique position that they hope to have more down markets.

You would have invested $42k in this 3 years which more or less is your current portfolio cost.

If the bear doesn’t come

A crazy bull like the one in the 1990s can run for an extended period, or that the bear market in 1994 is so small historically that had you pull out all your money 100% and waiting for a 30% drawdown you would have been disappointed.

Your 40k will still be in the market working in that scenario, with another 14k of yearly funding always

Visualize and fortify your mind

Behavioral finance is a rather important school  because we humans make the darnest mistakes.

Test drive a bear market or a small correction  or continuation to see if your plan works well.

And do remember the importance here of paying yourself first by funding your wealth building

If you like this article do share it with your friends. You will like the articles here as well.

Get Rich: How to Pay Yourself First

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The key to sustainable wealth building is not just to put savings above all else, pay yourself first, built psychological mechanisms based around habits and goals to ensure a stream of cash flow for you to build your wealth.

Introduction

This article is part of my wealth building series. If you are new to this, do read the first of the series, where I show you a simple formula to become wealthy .

Read enough personal finance books or blogs and you should see this term “Pay yourself first” tout around as much as the power of compounding.

Pay yourself first basically means that before you plan how to spend your money on entertainment, giving to parents and other goals, allocate an amount for yourself into your own savings.

Many readers ask me how they should get started in investing, when to get into the market. It is most often not when you are in the market but whether you have the cash to take advantage of opportunities.

If you have a stream of cash flow coming in every month, it matters less that a bear is coming your way. If you are 100% invested, an annual cash inflow of 15k would allow you to buy at bear market low prices.  Without it, you would have to liquidate existing holdings at a loss to fund better opportunities.

To me, if you cannot create a meaningful cash flow into your investment savings account, you shouldn’t even venture so far into investing.

Get the fundamentals right and paying yourself first is the most fundamental. Regular consistent savings contributions go a long way toward building a long term nest egg.

While the concept is good, its application is difficult and today we can take a look at why this is and some ways we can circumvent it.

Our society Gratifies Spending instead of Saving

We live in a society that constantly bombard the consumers with advertisement on TV, internet and newspapers.

On top of that, rising affluence and peer pressure breeds more prideful individuals who competes with one another to have more extravagant wants.

This creates a social norm that you:

  • have to go for one holiday per year to relax
  • you have to buy this gadget because you have a use for it
  • have to get a car after working for x years because it is convenient
  • you have to get married in an extravagant ceremony

The root of why it is difficult to change is because since young we are taught by observing our parents and major education influence.

Some rich parents ingrain good money values in the child since young and they continue to build the family fortunes. Others don’t place great emphasis and they became spendthrift adults who wasted the entire family fortune.

Children of lower middle class parents watch their parents take expensive installment payments to get the latest electronics and holidays.

This can be correct at a young age, if the education system places an emphasis on this. Which it doesn’t

Good Habit Compounds. So does Bad Habits.

In the end, everything compounds. And habits are psychologically very hard to change.

If you build a bad habit, such as smoking in your secondary school toilet at 14 years old, not brushing your teeth well, don’t stand straight, you will have a bloody hard time changing them when you get older.

If you start saving $2 out of the total your mom gave you every week in secondary school, then slowly increasing to $4 in poly and junior college, it becomes easier to automatically put away $300 per month when you come out to work.

A great article I came across on compounding is written by Blair Livingston. If you don’t think habits and compounding matters, read the article.

We are lazy and sabotage ourselves

While we all know that saving money is good, and that we have to do it, we won’t do it today. We keep telling ourselves we will do it tomorrow.

And we know we will never do, mostly because its just so much easier and that to kick start saving it is so troublesome.

Why does endowment plans work? Because we get hounded by our insurance agent who did everything for us! Had we have to do so much paper work, I wonder how many would go through with it.

We have strong Loss Aversion

Another reason is that even though setting aside $X is reasonably easy to do, many view it differently. They viewed it that you are taking money away from them that they couldn’t spend.

People inherently, intuitively, mentally, emotionally frame savings as a loss!

Its a lot more fun to spend now

How you can overcome this

With that in mind, we know that a lot of the problems have not got to do with the money itself. It has got to do with us:

  • Cultural Problem
  • Habitual Issues
  • Loss Aversion
  • Aversion to complexity

The solutions are to take into consideration these factors and design around them.

 

(Click to see larger image)

Building wealth by paying yourself first entails much of what is  illustrated  above.

1. Consciously Separate Money Meant for Wealth Building from Money for Other Purposes

Similar to giving your pet a name, providing a positive, feel good name that you can associate with will increase the motivation to reaching your goal.

In this case, some of my friends called them

  • Investment Warchest – appropriate name if you are an aggressive builder
  • Do Not Touch Fund – I don’t like this name because it is so negative and perhaps you missed out on the opportunity to grow it
  • Savings + Investing – quite well name but rather long. Perhaps doesn’t highlight the end objective
  • Wealth Chest – This is what I use to call mine. At the end of the day we are building wealth, whether we take less or more risk, and chest is an olden days storage for how people store their wealth

Your Wealth Building fund will be prioritize above anything:

  • You do not use this for holidays
  • You do not tap this for emergency
  • You do not tap this for your hobbies
  • You do not take this out to borrow to friends or relatives

These are strictly for you to accumulate wealth.

2. Schedule Money Transfers for this Separated Money in #1 into a Bank Account

As habits are hard to change, build enforce way of savings is a good idea.

That is why insurance agents are having a field day selling endowment plans. Endowment plans are not cheap but many folks think they have no other choices.

A friend of mine showed me a 20 year endowment maturing in 1 years time. The likely annualized return? Nearly 1.4%. And you have to pay your adviser $2,400 in commission for it.

Many savings account can create scheduled transfer to other savings accounts.

This make it easy for folks to create their own form of forced endowment saving.

One of your account would be the account where your pay is credited to you.

  1. Go to a bank and create another account. This physical account will be your Wealth Building Account.
  2. Don’t apply for an ATM card for this bank. Use internet banking to do any of the transactions
  3. If your pay gets credited on the 10th of every month, schedule an automatic transaction to the Wealth Building Account on the 11th of every month.

That’s it!

You just created your own commission free endowment plan. And it bypass the list of problems we highlighted above:

  1. The money gets “boxed out” from you before you even see it. So it is not taken away from you
  2. You work within a smaller pool. Sooner you will adjust and realize there is no difference

If you make a mistake spending this main bulk, at least your main savings are intact. ( Even though I do recommend that you do budgeting for this main bulk of savings)

Best Is that you don’t have to give a large portion of your money in the form of commission to agents.

3. Put the Money from your Wealth Building Account into Higher rate savings and Investment

Your Wealth Building Account objective is to accumulate a nest egg so that in the future, you do not need to work so hard, or that it enables you to have an adequate retirement.

 

To ensure you reach your goal, a simple wealth building strategy entails selecting one of the wealth building methods based on your time available, competency/edge,  level of risk tolerance and time horizon.

  1. Lower risk savings
  2. Property
  3. Passive portfolio investing
  4. Active Trading
  5. Value Investing
  6. Active Business Building

For the average folks I would recommend 1 and 3. This would entail you

  1. Taking adequate risk to build wealth
  2. Periodically review your Wealth Account and Sub Accounts on a quarterly or semi annually basis
  3. Restricting the chances of you to self sabotage your portfolio
  4. Concentrate on living life, watching your children grow up, making more money through what you are strong at

If you think that you are above others and that active investing is your strong suit by all means go ahead with (6)

  1. Whether you create a fixed deposit, a brokerage account the funding you draw from will be this Wealth Account  in (2)
  2. When you realized any capital gains, interest income, dividend income all these returns will flow back to the Wealth Account (2)

This way your money keeps recycling in building wealth and compounds. 

4. Track and Visualize your Wealth Building Account to stay Motivated

What I think is important is to simulate and show yourself that your little savings along the way amount to something significant.

There is a 40 page thread in Hardwarezone Forum talking about Portfolio Networth. Many find it difficult to hit $100k portfolio value by age 30. I think it may not be.

Enter a typical fresh graduate at 25 years old, who earns a gross salary of $2700.

  • 2 months bonus (no AWS)
  • Take home pay: $2160
  • Monthly funding to pay yourself first to build wealth: $1100
  • Bonus funding to pay yourself first to build wealth: 2 months (2160 x 2 = $4320)
  • 5 year saving visualization: 5 x [(1100 x 12) + 4320 ] = $87,600

We are still short of our $100k target, but do remember that I didn’t factor in any 3-4% salary increments or portfolio appreciation.

At the end of the day, you may think how in the hell can someone save 50% of their take home pay and  all their bonus, well there are many single individuals who are either too busy at work or have utterly no hobbies to be able to save that much.

The fact is that if you visualize, and come up with a comfortable plan, you are likely to stick to it because you are able to see the end result.

For myself, I tend to set the bar lower. I don’t really wish to increase my investment savings amount in the near future.

So I fixed that for the next 10 years,

  • $25,000 per year
  • $6,000 dividends per year

This should add $300k to my current portfolio without much dividend appreciation, portfolio appreciation.

I created this spreadsheet to visualize how much income it would generate.

A manageable goal and significant end result creates  buy-in psychologically and ensures greater probability you will stay the course.

5. Start Today and make Building Wealth Actionable

Although we talked about visualizing the end state, even if you do not hit your target it is important to start.

The key here is to start getting into the groove of building up this warchest.

You are creating that habit.

Once it gets to a certain stage, it will be like brushing teeth. You will feel that it is natural to live with a smaller subset of your disposable income.

If you don’t start because you think it is insignificant, you can’t get into this groove in the future.

6. Pay yourself a comfortable amount

 

A lot of people take paying themselves first means putting money from bonus into this. I don’t really advocate that as its not paying yourself first. You are not prioritizing wealth building over other values.

On the other end of the spectrum, there are folks that live like a hermit and just channel and channel more funding into wealth building. Its good that you value wealth building that much but there are other goals in life as well.

If you push your wealth building to the very limit, chances are you left yourself deficient in other areas such as health, family and well being.

You don’t want your wealth building goals to be impeded by unanticipated change in employment situation or unanticipated spending needs, thus it is better to keep a manageable amount.

You may be more comfortable paying yourself first 1 month of your 2 months bonus just to be on the safe side.

You may be more comfortable funding $400 per month instead of $700 per month and neglecting your kids education.

How differently do you pay yourself first?

I know many will use a Pru-cash or Pru-save account. Some others use the Philips Sharebuilder plan and monthly add XXX amount into blue chip stock like Singtel or STI ETF.

What other things did I missed out?

To get started with dividend investing, start by bookmarking my Dividend Stock Tracker which shows the prevailing yields of blue chip dividend stocks, utilities, REITs updated nightly.

Make use of the free Stock Portfolio Tracker to track your dividend stock by transactions to show your total returns.

For my best articles on investing, growing money check out the resources section.

5 steps to make the power of compounding work in dividend income investing

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A question on many investors mind is that we always say that we invest because we want to make our money work harder. Working harder here is to make use of the power of compounding over time.

However, how do we relate this to dividend income investing? What are the things we need to watch out for? Today we will fit this into our action plan to compound dividends.

Power of compounding

Power of compounding over time in layman terms is to earn on an investment, put that earnings back into the investment or another investment to earn more and continue to do that.

If you invest $1000 in Singapore Press Holdings (SPH) and you invest in SPH knowing it will earn you $60 for a 6% yield per year.

If you take the $60 out of your portfolio to buy some other things you want, in 20 years you will earn:

$60 x 20 = $1200

Compare this to if you take all these dividend cash earned from SPH back into SPH, your returns will be $2399.56 (computations below)

End of YearAccumulated ValueReturnsReturn difference from principal
0$1000.00$1000.00 x 1.06 = $1060.00$60
1$1060.00$1060.00 x 1.06 =  $1123.60$123.60
2$1123.60$1123.60 x 1.06 =  $1191.06$191.06
3$1191.06$1191.06 x 1.06 = $1262.48$262.48
4$1262.48$1262.48 x 1.06 = $1338.23$338.23
5$1338.23$1338.23 x 1.06 = $1418.52$418.52
6$1418.52$1418.52 x 1.06 = $1503.63$503.63
7$1503.63$1503.63 x 1.06 = $1593.85$593.85
8$1593.85$1593.85 x 1.06 = $1689.48$689.48
9$1689.48$1689.48 x 1.06 = $1790.85$790.85
10$1790.85$1790.85 x 1.06 = $1898.30$898.30
11$1898.30$1898.30 x 1.06 = $2012.20$1012.20
12$2012.20$2012.20 x 1.06 = $2132.93$1132.93
13$2132.93$2132.93 x 1.06 = $2260.90$1260.90
14$2260.90$2260.90 x 1.06 = $2396.58$1396.58
15$2396.58$2396.58 x 1.06 = $2540.35$1540.35
16$2540.35$2540.35 x 1.06 = $2692.77$1692.77
17$2692.77$2692.77 x 1.06 = $2854.34$1854.34
18$2854.34$2854.34 x 1.06 = $3025.60$2025.60
19$3025.60$3025.60 x 1.06 = $3207.13$2207.13
20$3207.13$3207.13 x 1.06 = $3399.56$2399.56

 

However, it is even more crazy if you can consider that the 6% dividend grows at a conservative 2% per year. Instead of returning $2399 the return now is $3445 from the original capital. Your original yield on cost increases from 6% to 8.92%.

The lesson here: To make more money do not take your money out of your portfolio. Re-invest in it.

The important aspects of compounding in dividend income stock

Based on the compounding example above it is easy to see where are the flaws of this when we realistically talk about compounding of a dividend stock like SPH

Growth rate is important. Stock’s dividend yield do not grow consistently at 6%. Some bad years it may be 2%, some years it will give special dividend, thus your yield will be 12%.

Do not underestimate the importance of special dividends. This article shows you that special dividends, bonus shares and spin offs can determine a lot of the astronomical returns.

In some years they do not pay at all. In some years you may even lose money if the growth rate is negative!

Failure for stock to maintain or grow their dividend payout at the required growth rate could ultimately make this stock less appealing then another stock on the market.

Dividends are pay out of profits and cash flow. Many look at dividends at the be all end all but to pay out a sustainable dividends, the stock needs to be not just profitable but earning enough to pay for it.

At Investment Moats, we define a sustainable dividend payout either as a dividend payout less than free cash flow or net profit. [Explaining free cash flow and net profit >>]

A sustainable and growing free cash flow and net profit is important to the sustainability of a 6% dividend yield.

Choosing the right dividend stock is important. Many a time we buy a stock for its dividend only that it turns out to be a dud

  1. Unable to continue paying 6%. Some companies business model gets eroded by competition, substitutes that what used to enable them to be lucrative just ain’t that good anymore
  2. Take on more debts to pay dividends, which will eventually proof to be unsustainable. (Think Willas Array)
  3. Cook their books by using dividends to entice investors only the cash to pay dividends is not there at all (Think fraudulent S-Chips)

It is important to evaluate the business of a dividend stock to see whether it can continue to pay the dividends that you require. To guard against fraudulent risks or imperfect knowledge holding a portfolio of dividend stocks is important rather than concentrate on 1 or 2 stocks.

Your Action Plan to Compounding Dividends

Taking into considerations the important aspects mentioned, how should you go about compounding through dividend investing?

To put it simply, put the following widgets into your action plan:

  1. Identify a list of reliable dividend paying stocks. Know their economic moat, strength and weakness, their risks and their profit and cash flow sustainability and growth capability.
  2. From this list, evaluate which of them are beaten down or presents a good value proposition.
  3. Invest a comfortable amount of your “Investment Warchest” into them.
  4. Collect your dividends, capital returns and together with your additional savings set aside for investments, put it into an “Investment Warchest”.
  5. Periodically review Step 1 and 2 and invest your “Investment Warchest” or prune your existing holdings.

1. Identify a list of reliable dividend paying stocks

To reinforce and to guard against what was outlined in the importance aspects of compounding in dividend income stock, always treat it as an exercise to understand the companies you currently invest in, do want to invest in, or do not want to invest in.

Understand their

  1. Economic moat. What makes this business a better business then the rest. What is the edge of this business model.
  2. Strength and Weakness. How it measures up versus its competition or why this business is not good to invest in.
  3. Sustainability of profit and cash flow. Is the cash flow growing? Can it sustain the dividend payout? Is this huge cash flow a one time event? Is this loss a one time event?
  4. Risks to operability and going concern. Can this company pay off its debts? Is it holding too much debts? Does the company have a law-suit or major impairment that would impede profitability currently or in the long term. Can it get its loans refinance?

2. Evaluate the value proposition

Its important to know how the business or how the stock generates the dividends. However, it doesn’t mean a good company is a good investment.

Total access communication which I identified in June this year was paying a dividend yield of 9% in March 2011. Buying the stock then would be a great proposition.

Since I identified it late and was waiting for it to come down it has ran up almost 50%. The current yield now is only 5%.

9% versus the average REITs listed on my Dividend Stock Tracker is great, but 5%? I think we can spot many better stocks with higher yields.

Of course dividend yield versus the prevailing market dividend yield is only 1 metric. It is a long topic which we will discuss more in the future and this goes hand in hand with Step 1, which is very important for this step.

Ultimately we hope to uncover fifty-cent dollar. This means that you get to buy 1 dollar for only fifty-cent.

3. Invest a comfortable amount of your “Investment Warchest”

I like to term my cash holdings set aside for investing as my “Investment Warchest”. To guard against things you cannot control, it is advisable to not concentrate your initial buying all at once and in only 1 or 2 stocks.

While step 1 and 2 when done right can weed out the duds, ultimately there are certain businesses that cook their books so well that even the pro analyst who are in constant contact with management cannot see it.

In some other cases, they are not fruadulent, their models are just breaking down. When you review it, your portfolio is already down a lot. Diversification ensures that it is not a sizeable chunk.

The key here is also not to over-diversify, such that it takes too much effort to monitor them. You are not a full time investor with the time to do that. I suggest not more than 20 stocks. Use Step 5 to prune when you have to.

4. Collect dividends, savings and add to “Investment Warchest”

The problem with starting small is that your dividends might not allow you to re-invest readily. Imagine your dividends from SPH being only $120. What can you buy with that?

The key is to pool your dividends together. That way you can invest in a stock that enables you to put your money back to work.

Now, most likely as part of a sound financial plan you will pay yourself first and set aside money for wealth accumulation and preservation. Collect them in this “Investment Warchest” as well.

5. Review Step 1 and 2. Continue to invest and prune your portfolio

Step 5 is the recurring step. It is also the one that demands you to be discipline and industrious. You are not going to collect dividends only for 1 month but through out the year and for many years.

Every month you will add savings to your “Investment Warchest”, you will need to put it to work as well.

To re-invest that, and the rest of the cash in your “Investment Warchest”, you will have to consistently take a look at prospective stocks and the stocks you own.

  1. Most of your holdings may hum along nicely.
  2. Some of them may have grown well.
  3. Some of them may be in trouble for a while or for a foreseeable future.
  4. There may be great stocks that suddenly appear to be at great prices

The important thing is to weed out those that are in (3). If they have fallen but you know their business is strong and it’s a short term problem, your next investment prospect could be this.

Those in (1) may still look very valuable even if they had grown with the general market. Some checkmarks here is compare to other stocks on your prospective list, they appear to be of higher value then the others.

In contrast, there could be those bargain dividend stocks in recession or sharp corrections that you want to buy but they were at $1. Now you get to buy them at $0.80 or $0.50.

The key is to develop investing, valuation and portfolio management as a lifelong hobby.

Conclusion

I hope that I have highlight to you folks how compounding in dividend investing comes into play. There are some caveats to it compare to what we normally know like bank interest rate and bond interest rate. This happens because stocks do fall or rise in value. Compounding is not so visible.

As such the key is for cash flow of the stocks to grow and re-investment. I hope that through my five step plan it makes it simple for you guys.

Do let me know if you have any questions.

I run a free Singapore Dividend Stock Tracker . It  contains Singapore’s top dividend stocks both blue chip and high yield stock that are great for high yield investing. Do follow my Dividend Stock Tracker which is updated nightly  here.