Warren Buffett In His Own Words, Plus Some Other Timeless Quotes

I first wrote this article in 2007. By page views, it is the most popular article I have ever published, having been read by more than 15,000 people.

The original article contained 23 timeless quotes by Warren Buffett. In this re-write, I have removed a couple of the originals and replaced them with others that I like better. I have also included a few other great quotes from such sages as Yogi Berra and Woody Allen. Not all of them were about investing, but all can be applied to investing.

Warren Buffett’s best sound bites of all time on being a sensible investor.

1. Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.

2. Investing is laying out money now to get more money back in the future.

3. Never invest in a business you cannot understand.

4. I don't look to jump over 7-foot bars: I look around for 1-foot bars that I can step over.

5. I put heavy weight on certainty. It's not risky to buy securities at a fraction of what they're worth.

6. If a business does well, the stock eventually follows.

7. It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

8. Time is the friend of the wonderful company, the enemy of the mediocre.

9. For some reason people take their cues from price action rather than from values. Price is what you pay. Value is what you get.

10. Risk comes from not knowing what you're doing.

11. It is better to be approximately right than precisely wrong.

12. You do things when the opportunities come along. I've had periods in my life when I've had a bundle of ideas come along, and I've had long dry spells. If I get an idea next week, I'll do something. If not, I won't do a damn thing.

13. What we learn from history is that people don’t learn from history.

14. You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.

15. You don't need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.

16. You should invest in a business that even a fool can run, because someday a fool will.

17. When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.

18. The best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.

19. Diversification may preserve wealth, but concentration builds wealth.

20. Someone’s sitting in the shade today because someone planted a tree a long time ago.

21. Many in Wall Street—a community in which quality control is not prized—will sell investors anything they will buy.

22. There seems to be some perverse human characteristic that likes to make easy things difficult.

23. Our favorite holding period is forever.

And here are the quotes from a few others:

1. Hindsight is much more precise than foresight but not as valuable. (Dwight D. Eisenhower)

2. If you don’t know where you’re going, you’ll end up somewhere else. (Yogi Berra)

3. It ain't over 'til it's over. (Yogi Berra).

4. Promise me you'll always remember: You're braver than you believe, and stronger than you seem, and smarter than you think. (Christopher Robin to Pooh, written by A. A. Milne)

5. A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. (Winston Churchill)

6. Investing is easy. Buy stocks that go up. If they don't go up, don't buy them. (Will Rodgers)

7. Eighty percent of success is showing up. (Woody Allen).

8. The race is not always to the swift, nor the battle to the strong—but that's the way to bet. (Damon Runyan).

Timing Outlook Remains Positive at 9.5

1. Summary

Since the last report 2½ weeks ago, the market has just gone pretty steadily up, making gains in 11 of the past 12 days through Wednesday. The Timing Outlook remains elevated at 9.5. As last time, the only indicator that is neutral instead of positive is Morningstar’s Market Valuation Graph, which at 1.05 suggests that the market is 5% overvalued right now. Every other indicator is positive.

The steady trickle of up-days raised the percentage of up-days such that my additional criteria for buying into the market were satisfied. Thus I am now 100% invested in my Capital Gains Portfolio, which requires 2/3 up days—along with the positive Timing Outlook—to make an investment.

As stated last time, the Capital Gains Portfolio’s investments simply are in the S&P 500-tracking SPY ETF. Most of my time recently has been devoted to working on THE TOP 40 DIVIDEND STOCKS FOR 2011, so I have not had time to evaluate individual stocks for the Capital Gains Portfolio. The SPY shares are protected by a tight 5.5% trailing sell-stop. My confidence in the rally has improved a little, for two reasons. First, I like slow, steady trends. Second, the tone of the “net news flow” seems to have changed from generally downbeat to somewhat positive. That’s my subjective judgment, anyway.

I hope everyone has a great Christmas, New Year, and/or whatever else you celebrate at this time of year. When the year has ended, the market will probably have gone up >10-11% for the year in price, plus another couple percent for dividend investors. That makes it a pretty good year in my book.

2. Market Performance Since Last Outlook
(“now” figures are as of close Wednesday, December 22, 2010)

Last Outlook (12/4/10): 9.5 (positive)

S&P 500 last time (12/4/10): 1225
S&P 500 now: 1259 Change: +3%

S&P 500 at beginning of 2010: 1115
S&P 500 now: 1259 Change in 2010: +13%

S&P 500 at close 3/9/09 (beginning of bull market): 677
S&P 500 now: 1259 Change since 3/9/09: +86% (in about 22 months)

3. Indicators in Detail

• Conference Board Index of Leading Economic Indicators: December’s report, out last Friday, showed another increase, the fifth in a row. That keeps this indicator positive. +10

• Fed Funds Rate: No change. The Fed is clearly committed to a loose money policy until the economy is well into recovery or they become concerned with inflation. Positive. +10

• S&P 500 Market Valuation (P/E): Morningstar pegs the current P/E of the S&P 500 at 14.7, same as last time. This is well within positive territory (any value below 17.4). +10

• Morningstar’s Market Valuation Graph. Morningstar’s proprietary market valuation graph is at 1.05, up from 1.03 last time, suggesting that the market is 5% overvalued right now. This is still well within my 10% range of 1.00 for calling this indicator neutral. I like this indicator a lot, because of the unique and sensible way they construct it. You can see it by clicking here. Use the tabs across the top to see different timeframes and types of stocks. +5

• S&P 500 Short Term Technical Trend: This short-term technical indicator uses the two shorter (20-day and 50-day) simple moving averages (SMAs) of the S&P 500. The current configuration is the best you can get: Index > 20-day > 50-day. +10

• S&P 500 Medium Term Technical Trend: This medium-term technical indicator uses the two longer SMAs (50-day and 200-day). Right now it tells the same story: Index > 50-day >200-day. Positive. +10

• DJIA Short Term Technical Trend: Same story as the S&P 500 short-term trend. Positive. +10

• DJIA Medium Term Technical Trend: Same story. Positive. +10

• NASDAQ Short Term Technical Trend: Same story. Positive. +10

• NASDAQ Medium Term Technical Trend: Same story. +10

TOTAL POINTS: 95
NEW READING: 95 / 10 = 9.5 = POSITIVE

Interview with author David P. Van Knapp

A promotional video for my first book, SENSIBLE STOCK INVESTING: How to Pick, Value, and Manage Stocks, has just been completed. We shot 90 minutes of tape to get the raw material for this 1:44 video. I'm not quite as dynamic as the Sham Wow guy, or Cramer, but that's why I called the book "Sensible."

"THE TOP 40 DIVIDEND STOCKS FOR 2011" Nearing Its Final Stages

In earlier posts, I described the various stages and processes that I use to produce THE TOP 40 DIVIDEND STOCKS series. Here is where things stand for the 2011 edition.:

• I have passed all of the 136 survivors of Stage 1 testing through Stage 2. In that second stage, all of the stocks were again subjected to the six fundamental Stage 1 tests, but this time with no "easing" of the requirements. In addition, I applied several additional tests designed to anticipate how the stocks were likely to score when I applied my Easy-Rate standards to them. As I have stated, I love to eliminate stocks--it's like eliminating the non-contenders in a horse race. After you do it, you have the pleasure of knowing that you are looking at the likely winners of the race. This year's Stage 2 phase dropped the 136 survivors of Stage 1 all the way down to 46 "Semi-Finalists." The 90 stocks that didn't make it were removed to a "2012 Contenders" document, where they joined the stocks that were eliminated in Stage 1. I will maintain that document throughout next year, as it will become the pool of candidates a year from now (along with all the survivors) for 2012.
• Stage 3 consists of preparing the "Company Quality" portion of the Easy-Rate scoresheets for all of the survivors. Thus I write (or re-write) their Stories; study their EPS growth rates, ROEs, debt ratios, and other financial factors; and rate their dividend prowess (current yield, years increased, average rate of increase, and the like). The result is a Company Quality score using a system that has been optimized for dividend-growth stocks. (I tinker a little with the system each year based on new learnings and insights.) As I complete the analysis of each stock, I place it in a table in order of its Company Quality score. I also record the stock's current yield, as that may be used as a tie-breaker in selecting the Top 40.
• I have just about completed Stage 3. When I finish,  I will have ranked the 46 Semi-Finalists by Company Quality. That list will then be frozen until the first of the year. (If you saw the weather up here in Webster, NY, you might think I mean "frozen" literally.) In a first for us, my wife and I are driving to Florida on January 2-4. By the time we arrive, full-year 2010 data should be available. At that time, I will value the stocks using my Easy-Rate stock valuation system and update the Company Quality scores. That will give me all the information I need to pick the Top 40. If there are any ties, I'll select the stock with the higher yield--all other factors equal, higher yield is better.
• I will also go through the text at least one more time. I will have full-year 2010 statistics about dividends generally and also be able to complete the table showing how 2010's picks did for the full year. As I said in an earlier post, I am adding a new chapter this year on Retirement Financing, and I want to go over that again. This is the time to catch errors, from important logical mistakes down to little spelling errors.

Once those operations are complete, I can assemble the book. The Top 40 Easy-Rate sheets will have been completed and can be moved right into the final manuscript document. Certain mechanical operations must be performed, including converting the manuscript into a PDF document, "loading" the document to Payloadz (the company that I use for secure distribution), removing the 2010 edition from Payloadz, and setting up PayPal to accept credit/debit card payments for the new edition. Both my wife and I will go through the ordering process ourselves to make sure that it works and is intuitive. Then it will be ready for launch, hopefully some time around January 15-20.

Interesting tidbits: 32 of the 46 Semi-Finalists have been a Top 40 pick in 2008, 2009, and/or 2010. That is not a surprise: It takes a special kind of company, with lots of great characteristics, to survive this kind of analysis. Certain companies have been on that plateau for years and are simply excellent companies that  many would call Blue Chips. But some of the other Semi-Finalists are relatively new to the dividend-raising world (I require at least 5 consecutive years of increases to be eligible at all). Maybe they are the Blue Chips of the future and now is the time to get in on the ground floor. The Semi-Finalists represent all manner of size and many industries. Most but not all are domiciled in the USA. Even if domiciled in the USA, most get close to or more than half their revenues from outside the country. When you go through an exercise like this, the ongoing globalizaton of companies and markets just jumps out at you. My take: You do not have to invest in foreign companies to gain access to many of the opportunities represented by global markets and developing economies. These companies are already doing it.

September-October-November Rally Continues Into December; Timing Outlook Positive at 9.5

1. Summary

The chart tells the story. (Click on the chart to enlarge it.) The market has been generally rising since the beginning of September. This is reflected in the high reading for the Timing Outlook, currently 9.5, up from 9.0 last time. The only indicator that is neutral instead of positive is the Morningstar Market Valuation Graph, which clocks in at 1.03, suggesting that the market is 3% overvalued right now. Every other indicator is positive.

The strange thing about this rally is that there have been quite a few down days (shown in the red candlesticks and in the red volume bars at the bottom of the chart). They have been more than offset by occasional large one-day lifts. This characteristic has kept me from becoming fully invested in my Capital Gains Portfolio, which requires 2/3 up days—along with the positive Timing Outlook—to make an investment. The proliferation of small down days has kept the portfolio from fully participating in the 3-month rally. I check approximately every week, and if the conditions are right, I invest 10% more cash. The portfolio is about 70% invested (30% cash) at this time.

While the slowed pace of re-investing costs me some gains when the market rises as unevenly as it has, I nevertheless continue to follow the 2/3 rule. It provides a margin of safety and conservatism that has served me well over the long term. It does guarantee that I will miss the beginning couple weeks of any rally.

As stated last time, The Capital Gains Portfolio’s only investments currently are in the S&P 500-tracking SPY ETF. Most of my time in the last three months has been devoted to preparing 2011’s edition of THE TOP 40 DIVIDEND STOCKS, so I do not have up-to-date Easy-Rate™ sheets for individual capital-gains stocks. SPY allows me to participate in the market rally without having currently rated individual stocks.

The SPY shares are protected by a tight 5% trailing sell-stop. This has not been a high-confidence rally for me. The uneven nature of the market’s rise shows that it is prone to react quickly to negative news on any particular day. That suggests to me that lots of investors have their fingers on the Sell button. Friday’s increase in the unemployment rate to 9.8% from 9.6% certainly did not increase confidence in the recovery. Despite that, interestingly, the market went up Friday. Those who believe that the market is always rational need not apply. I think that it is rational in the long term, but is unpredictable—nearly random—in the very short term of a few days.

As mentioned last time, I have re-named my Dividend Growth Portfolio to emphasize its focus on rising-dividend stocks. That portfolio remains 100% invested, as it usually is. Because the focus there is on continually increasing the dividend stream, I don’t use sell-stops or go to cash when the market plunges. The only cash is accumulated dividends waiting to be reinvested when the total hits $1000. As stated earlier, I am deep into preparation of THE TOP 40 DIVIDEND STOCKS FOR 2011. I will keep you up to date on its progress. I hope to release it in January, and I am still on schedule to do that.

2. Market Performance Since Last Outlook
(“now” figures are as of close Friday, December 4, 2010)

Last Outlook (11/12/10): 9.0 (positive)
S&P 500 last time (11/12/10): 1199
S&P 500 now: 1225 Change: +2%

S&P 500 at beginning of 2010: 1115
S&P 500 now: 1225 Change in 2010: +10%

S&P 500 at close 3/9/09 (beginning of bull market): 677
S&P 500 now: 1225 Change since 3/9/09: +81% (in about 21 months)

3. Indicators in Detail

• Conference Board Index of Leading Economic Indicators: The most recent report in November showed an increase in this index, the fourth in a row. That keeps this indicator positive. +10

• Fed Funds Rate: No change. The Fed seems committed to a loose money policy until the economy is well into recovery or they become concerned with inflation. Positive. +10

• S&P 500 Market Valuation (P/E): Morningstar pegs the current P/E of the S&P 500 at 14.7, down slightly from 15.1 last time. This is still well within positive territory at any value below 17.4, suggesting that the market is undervalued. +10

• Morningstar’s Market Valuation Graph. Morningstar’s proprietary market valuation graph is at 1.03, up from 1.01 last time, suggesting that the market is 3% overvalued right now. This is well within my +/- 10% range for calling this indicator neutral. As you can see, this indicator's suggestion is different from the suggestion of the market's P/E just stated. +5

• S&P 500 Short Term Technical Trend: This short-term technical indicator uses the two shorter simple moving averages (SMAs) of the S&P 500. The configuration has become even more positive than last time, as the Index > 20-day > 50-day picture has become more pronounced. +10

• S&P 500 Medium Term Technical Trend: This tells the same story: Index > 50-day >200-day. The index is up about 4% since the “golden cross” (the upward passage of the blue 50-day SMA through the red 200-day SMA) on October 22, visible in the middle of the chart. Positive. +10

• DJIA Short Term Technical Trend: Same story as the S&P 500 short-term trend. Positive. +10

• DJIA Medium Term Technical Trend: Same story. Positive. +10

• NASDAQ Short Term Technical Trend: Same story. Positive. +10

• NASDAQ Medium Term Technical Trend: Same story. +10

TOTAL POINTS: 95
NEW READING: 95 / 10 = 9.5 = POSITIVE

Top 40 Dividend Stocks for 2011--Progress Report

I have completed what I call Stage 1 work on The Top 40 Dividend-Growth Stocks for 2011. This work consisted of the following:

• A complete re-write of the text. I made two major changes to the text this year. First, I condensed my 5-article series on retirement funding into a single new chapter for the book. I incorporated a few additional ideas that came to light in the comments I received on the original articles as well as further thinking I have done on the topic. Second, I combined two chapters (formerly called "What Are Dividends?" and "Why Invest in Dividend Stocks?") into a single new chapter, "Why Invest in Dividend-Growth Stocks?" I did this to eliminate redundancies and try to create some space for the new chapter on retirement. The 2011 edition will contain about 17 more pages than 2010's edition. As usual, I also tinkered with the stock-scoring system. I bumped up the points available for a company's Story from 10 to 15 to reflect how important I think every company's business model and competitive position are. I changed the "look-back" period for dividend growth rates from 3 years to 5 years. I tightened the standards for Stock Valuation a little. I am more consistently using the phrase "dividend-growth stocks" instead of "dividend stocks" to emphasize the focus on companies that increase their dividends every year. That will also be relected in the title of the book itself.
• I completed the most tedious part of the whole project, which is reviewing more than 700 companies to select those that have any reasonable chance of being selected for the Top 40. There are 6 initial tests I put these companies through, including minimum yield, minimum yield growth, minimum number of years of increasing their dividends, and the like. This year's Stage 1 processing took 708 stocks and eliminated 572 of them. So 136 stocks remain for Stage 2 testing, which will begin immediately. Because I start testing stocks so early (in September), I use "eased" requirements that allow some stocks to pass forward if they just miss on one or two requirements. I do this because the numbers may change in the last 3 months of the year, and I don't want to drop a stock prematurely. Stage 2 will allow no easing. From past experience, Stage 2 will eliminate 20%-30% of the stocks. I love eliminating stocks, not only beause it reduces the work required in later stages, but also because I love to see the best of the best begin to emerge.

At the end of Stage 2, the stocks that remain will be the "Semi-Finalists." Those will then be put through many more tests than the initial 6 requirements. The best ones that rise to the front of the list will become the "Finalists." I'll choose the Top 40 from those some time in January.

I am still hoping to have the publication available in January. My final scoring of stocks and selection of the Top 40 cannot be completed until January, because I need year-end data. My wife and I have decided to take a southern trip just after the holidays, so I will lose a few days in the car. In 2010, I got the project published on January 19 (if I recall correctly). I am hoping to hit around that date again with this edition.

September-October Rally Continues Into November; Timing Outlook Positive at 9.0

1. Summary

The market has been generally rising since the beginning of September. Because the Timing Outlook has a number of technical trend-following components, the market action has pulled the Timing Outlook higher. Its reading currently is 9.0, up from 8.0 last time. That said, last week’s trading was mostly down, and the market had its first losing week in the last six weeks.

After four months of trading sideways, in a range of 1,040 to 1,130, the S&P 500 index finally passed through and stayed above 1,130 on September 20, and it has stayed above that level ever since. It closed Friday at 1199.

As frequent readers know, I require both a positive Timing Outlook plus the satisfaction of a separate set of criteria to invest money in my Capital Gains Portfolio. (Click the “CRITERIA FOR RE-ENTERING THE MARKET” link in the right-hand column to see the additional criteria.) In a nutshell, I look to invest in a “rising” market. The criteria define what that means.

After months of failing to meet the criteria, they were finally met on September 14, and they have generally stayed satisfied since then. I have invested 60% of my portfolio’s money back into the market, in 10% chunks. Generally I check at least once per week to see whether to make another 10% investment. While the slow pace of re-investing costs me some gains when the market rises as sharply as it has, I nevertheless continue to move deliberately. This approach provides a margin of safety and conservatism that has served me well over the long term.

I apologize that my only investments are in ETFs, which reduces the educational value somewhat. Because most of my time in the last three months of the year is devoted to preparing 2011’s edition of THE TOP 40 DIVIDEND STOCKS, I do not have up-to-date Easy-Rate™ sheets for individual capital-gains stocks. Therefore, for re-entering the market, I have been purchasing shares of SPY, one of the ETFs that track the S&P 500. Well, this is meant to be a demonstration portfolio, so I guess it is demonstrating what happens when you don’t have the time to keep up with everything that you would like to do.

The third-quarter earnings season, now winding down, has been strong but not fabulous. The “beat rate” for stocks (that is, the percentage of those exceeding analysts’ consensus earnings estimates) has been just a little higher than the historical average of 61%. Economic news has been choppy. The pace of the economy’s growth is unimpressive. The unemployment rate remains stuck at 9.6%. The housing market is recovering very slowly if at all. Every good economic report seems to be followed by an equal-but-opposite bad report within a day or two. The Federal Reserve has announced that it will buy more Treasury bonds in an effort to stimulate more economic growth. Last week was the market’s first losing week in five weeks. I have a tight 5% sell-stop under my SPY holdings.

My newly re-named Dividend Growth Portfolio remains 100% invested, as it always is. Because the focus there is on continually increasing the dividend stream, I don’t use sell-stops or go to cash when the market plunges. The only cash in that portfolio is accumulated dividends waiting to be reinvested when the total hits $1000. As stated earlier, I am deep into preparation of THE TOP 40 DIVIDEND STOCKS FOR 2011. I will keep you up to date on its progress. I hope to release it in January.

2. Market Performance Since Last Outlook
(“now” figures are as of close Friday, November 12, 2010)

Last Outlook (10/11/10): 8.0 (positive)
S&P 500 last time (10/11/10): 1167
S&P 500 now: 1199 Change: +3%

S&P 500 at beginning of 2010: 1115
S&P 500 now: 1199 Change in 2010: +8%

S&P 500 at close 3/9/09 (beginning of bull market): 677
S&P 500 now: 1199 Change since 3/9/09: +77% (in about 20 months)

3. Indicators in Detail

• Conference Board Index of Leading Economic Indicators: The most recent report in October showed an increase in this index, the third in a row. That satisfies my requirements for this indicator jumping from neutral to positive. +10

• Fed Funds Rate: No change. With the Federal Funds rate near zero, this indicator remains positive. As stated above, the Fed continues to try to cook up new ways to stimulate the economy besides keeping interests rates low. +10

• S&P 500 Market Valuation (P/E): Morningstar pegs the current P/E of the S&P 500 at 15.1, up slightly from 14.7 last time. This is still well within positive territory at any value below 17.4. +10

• Morningstar’s Market Valuation Graph. Morningstar’s proprietary market valuation graph is at 1.01, up slightly from 1.00 last time. This suggests that the market is fairly valued right now. Neutral. +5

• S&P 500 Short Term Technical Trend: This short-term technical indicator uses the two shorter simple moving averages (SMAs) of the S&P 500. Although the market’s fall on Friday pulled the index down close to its 20-day SMA, it finished above it. Thus the configuration remains the same as last time, Index > 20-day > 50-day, which is usually a positive picture. +10

• S&P 500 Medium Term Technical Trend: The medium-term configuration has risen to positive, as the 50-day SMA crossed upward through the 200-day SMA on October 21-22, the so-called “golden cross.” Many consider this to be one of the strongest technical indicators. Positive. +10

• DJIA Short Term Technical Trend: This chart looks similar to the S&P 500 chart, except that Friday’s close was slightly under the 20-day SMA. That makes this chart ambiguous. Neutral. +5

• DJIA Medium Term Technical Trend: On the Dow, the “golden cross” took place at the beginning of October. Positive. +10

• NASDAQ Short Term Technical Trend: The NASDAQ’s chart has the same configuration as the S&P for both time-frames, although Friday’s close was just a fraction above the 20-day SMA. Positive. +10

• NASDAQ Medium Term Technical Trend: Positive, after a “golden cross” on October 20-21. +10

TOTAL POINTS: 90
NEW READING: 90 / 10 = 9.0 = POSITIVE

THE TOP 40 DIVIDEND STOCKS FOR 2011 Is Well Underway

For the past month, I have been preparing the manuscript for THE TOP 40 DIVIDEND STOCKS FOR 2011. The process proceeds along two parallel paths:


--The screening and selection process for the Top 40 stocks themselves.
--The writing (or rewriting) of the text.


One significant change in the text next year is that I am adding a chapter on the role of dividend stocks in funding retirement. This new chapter is based on my five-article series on Financing Retirement that appeared here earlier this year. The series was very popular and generated significant comments. To convert the articles into a Chapter for THE TOP 40, I am rearranging and condensing the material. I am also working in new or refined concepts that that came up in the comments and in my responses to those comments.


I am also making textual changes to emphasize that the e-book is about dividend growth investing. The subtitle next year will be How to Accumulate Wealth or Generate Income from Dividend-Growth Stocks. References in the text to "Sensible Dividend Investors" are being changed to "Dividend Growth Investors." The e-book has always been about dividend growth investing (as opposed to, say, investing in preferred shares, whose payout rates do not grow). Now the text will be more consistent in reflecting that.


On the stock-selection side, I again this year started out with about 700 stocks. (I collect references to and recommendations of dividend stocks throughout the year.) I am about two-thirds done with paring this starting list down to the real contenders. I do this by applying several minimal requirements regarding yield, consistency of raising dividends, and the like. That will get the list down to around 200 stocks. Then another round of screening will pare the list further to the 75 or so stocks that actually have a realistic chance of being one of the Top 40.


I am aiming for a publication date in January. Some magazine articles or special issues about investing in 2011 are already hitting the shelves in stores. But I like to wait for the current year to end so that I can use full-year 2010 data in my analyses.


I will keep you posted on the progress of THE TOP 40 DIVIDEND STOCKS FOR 2011: How to Accumulate Wealth or Generate Income from Dividend-Growth Stocks every few weeks until the publication date.

Yield on Cost: How It Works

An important concept in income investing is yield on cost, but it is often misunderstood. Let’s look under the hood.

The basic idea is easy: Yield on cost is the income yield, right now, on money that you invested 10 minutes ago, a few months ago, or 10 years ago. It is determined by this simple formula:

Yield on Cost = Past 12 Months Income / Price You Paid.

I use the past 12 months’ income in this formula, because it is the only income we are sure about. (“Indicated” yield, based on the expected continuation of the most recent dividend payout, is also often used. I explain the nuances at the end of the article.)

Here’s an example taken from the latest Portfolio Review of my illustrative Dividend Portfolio. The review was conducted in August (read about it in this article: “Portfolio Forensics”), so the “Price Now” number is out of date, but it is perfect for illustration.
Stock  MCD (McDonald's)
Date Bought 4/30/08 and 3/30/09
Price When Bought $60.06 and $53.93
Price Now $71.70
Price Return 19% and 32%
Current Yield 3.1%
Yield on Cost 3.7% and 4.1%
Action to Take Hold

You can see that I purchased McDonalds twice, in April 2008 and again in March 2009. The “Current Yield” shows MCD’s yield at the time of the review, based upon its price then. Note that it is the same for both purchases. That’s because current yield is based on current price. There's only one current price.

Current Yield = Past 12 Months Income / Current Price

In contrast, the “Yield on Cost” shows two yields, one for each purchase. That’s because yield on cost is based on the price you paid, not what the stock is selling for today. Note how my first purchase (2008) is now yielding 3.7%, while my second purchase (2009) is yielding even more, 4.1%. That is because the price went down between my two purchases. Each of the two purchases of MCD pays out the same dividend per share, obviously. But when you convert that dollar number into a percentage yield on cost, the divisor is different for each purchase, hence there are two yields on cost. The only way they would be identical is if the price had been identical when I made each of the two purchases.

This simple example allows me to illustrate several bedrock principles of dividend growth investing.

Each time the dividend increases, your yield on cost goes up. I went back and checked the then-current yield of MCD on the dates I made the two purchases. In 2008, it was $1.875 / $60.06 = 3.1%. In 2009, it was 1.75 / 53.93 = 3.2%. (Don’t be misled into thinking MCD lowered its dividend from 2008 to 2009. At the beginning of 2008, MCD switched from a single annual dividend to four quarterly dividends per year. The 2008 calculation “caught” an extra quarter of dividends, namely the first quarterly payment in March 2008.) Because of MCD’s annual dividend increases, my yield on cost on the two purchases has risen from 3.1% to 3.7% for the first purchase, and from 3.2% to 4.1% for the second purchase. The increase in yield on cost is a mathematical certainty if the dividend is increased, because the divisor (the price you paid) remains the same for as long as you own the stock.

Yield on cost is a measure of current performance, not past performance. Some people feel that yield on cost is a backwards-looking measure. That is incorrect. Because it is based on the most recent 12 months’ dividend payout—the last annual amount that we know for sure—yield on cost is a current measure of performance. Of course, today’s yield on cost “got there” because of past dividend increases, but it is a current performance metric.

Yield on cost is directly comparable to a bond’s yield. Bonds, as we know, are fixed-income investments. You pay $x for the bond, and its yield is stated and set for the term of the bond. It is a contractual obligation of the bond issuer, to whom you have lent money by buying the bond. So if you bought a bond yielding 4% in 2008, it is still yielding 4% to you. It will always yield 4% to you. It may pay a different yield to someone who buys it on the bond market today (because its price may have changed), but that has no impact on its yield to you. Its yield on cost will always equal its yield on the day you bought it.

Yield on cost can be considered to be your “personal” yield on a dividend-paying stock. It is dependent on the price you paid. The current yield stated in the newspaper or on Yahoo or Morningstar applies to someone who purchases the stock today. It is irrelevant to your yield on cost.

The dividend increases in a dividend-growth stock can cause its yield to surpass that of a bond which may have started out ahead. As just stated, if you buy a bond yielding 4% and hold it, it will always yield 4% to you. But the increasing dividends of a dividend-growth stock will cause its yield on cost—your personal yield—to inexorably climb, often reaching and then surpassing the annual income on a bond that originally paid more. In the year following my 2008 purchase of MCD, it paid $1.75 per share in dividends, or 2.9% based on my purchase price. In the past 12 months, it has paid me $2.20, or 3.7%. That’s a 26% increase in dollars in just a year. Looking ahead, MCD has already announced an increase in its dividend for the fourth quarter of this year (from $0.55 to $0.61) an 11% hike that will raise the dollars to me in the next 12 months to $2.44, for a yield on cost of 4.1% on my 2008 purchase. (This is the forward-looking “indicated” yield on cost; see the last paragraph of this article.)

Price and initial yield matter. My 2008 purchase at $60.06 had sunk to $53.93 by the time of my second purchase in 2009. Why would I buy more of a sinking stock? Because it was a better deal--a classic value-investing concept. I had long-term faith in McDonald’s the company. I still do. I wasn’t thrilled that its price drop had cost me 10% in capital losses. But I didn’t plan to sell it, and in dividend growth investing one focuses on the dividend stream. In the year between the two purchases, MCD had jacked up its dividend from $1.50 in calendar 2007 to $1.625 in 2008 (an 8% jump), and it would jack it up another 26% in 2009 to $2.05. I could not have expected that magnitude of increase, of course, but I certainly expected an increase—after all, MCD had been raising its dividend for 32 consecutive years.

Yield on cost and current yield gradually diverge from each other. If a stock’s price increases at exactly the same rate that the company increases the dividend each year, the current yield won’t budge. This fakes out some people, who equate yield on cost to current yield. As we have seen, they are quite different, as the yield on cost rises with each dividend increase. Some dividend-growth investors believe the increasing dividends are themselves a major reason that dividend-growth stocks tend to wallop all stocks in total return. The reasoning is that if the price decreases, the current yield increases, making the stock more attractive to income investors, who pile into the stock and drive its price back up—so the stock’s price tends to rise along with its dividend. It is not unusual to see a stock’s current yield stay pretty much the same year after year, even though its dividend is raised each year. The dividend increases are matched by approximately equal percentage increases in the price of the stock, so mathematically the current yield stays the same. MCD’s current yield is 2.9%, and its indicated current yield is 3.2%, both in the same range as when I bought it in 2008 and 2009. But my yields on cost, as already explained, are much higher.

If you don’t separate out new purchases from old ones, your “blended” yield on cost will often go down with a new purchase. A new purchase at, say, 3.1% current yield, when combined with an old purchase at, say, 4.1% yield on cost, will make the combined yield on cost lower. (At the moment of purchase, yield on cost and current yield are identical.) That’s why I track each purchase separately. It makes clear what is really happening: The new purchase has not diminished the yield on cost of a purchase made years ago. That never happens. What does happen is that the yield on cost of the original purchase continues to march upwards, while the new purchase starts at its current yield on the day of purchase, then commences its own upward march when the next dividend increase is declared.

Finally, a couple of points about the basic formulas.

 (1) The formula for yield on cost could be Yield on Cost = (Last Quarter’s Dividends x 4) / Price You Paid. That formula differs from the one stated at the beginning of this article only in that it projects the current dividend payout rate forward (without presuming an increase). The proper name for this is “indicated” yield on cost.

(2) A similar change can be made in the formula for current yield, producing the “indicated” current yield.

September Rally Continues into October; Have Re-entered the Market for Capital Gains

1. Summary

The market has been generally rising since the beginning of September. The rally has pulled the Timing Outlook to a strongly positive reading of 8.0, up from 6.0 last time.

For over four months, the S&P 500 had stayed stuck in a trading range of 1,040 to 1,130, essentially going sideways. The index finally passed through and stayed above 1130 on September 20, and it has stayed above that level ever since, slowly drifting upward in fits and starts. (See the chart below. Click on it to enlarge it.)

As frequent readers know, I require not only a positive Timing Outlook but also the satisfaction of a separate set of criteria to invest money in my Capital Gains Portfolio. The additional criteria, again, are:
• 9% rise over two weeks, with at least 7/10 days positive
• 3% rise over 3 weeks, with at least 10/15 days positive
• 4% rise over 4 weeks, with at least 14/20 days positive
• 5% rise over 5 weeks, with at least 17/25 days positive
• Etc.

The criteria were finally met on September 14, and I invested 10% of the portfolio’s funds on that day and another 10% a week later. There have been enough “down” days sprinkled in since then, however, to keep me from investing any more. This has cost me some gains as 80% of the portfolio sits in cash, but I will continue to require the additional margin of safety that the second criteria provide. Long term, that discipline has served me well.

Because I am hard at work on 2011’s edition of The Top 40 Dividend Stocks, I do not have up-to-date Easy-Rate™ sheets for capital-gains stocks. Therefore, for re-entering the market, I have purchased shares of SPY, one of the ETFs that tracks the S&P 500. I am following the market at the end of each day, and if the second set of criteria are satisfied, I will make another purchase.

The market’s action for the past three months is shown on the chart. It shows that the S&P 500 has risen about 11% since the beginning of September. It also shows the number of “down” days (red candlesticks) that frustrate the second criteria, even though the overall direction has been upwards.

My Dividend Portfolio remains 100% invested after the changes described last time. By the way, I have begun to work on the 2011 edition of The Top 40 Dividend Stocks. I will keep you up to date on its progress. I hope to release it in January.

2. Market Performance Since Last Outlook
(“now” figures are as of mid-morning, Monday, October 11, 2010)

Last Outlook (9/13/10): 6.0 (positive)
S&P 500 last time (9/13/10): 1122
S&P 500 now: 1167 Change: +4%

S&P 500 at beginning of 2010: 1115
S&P 500 now: 1167 Change in 2010: +5%

S&P 500 at close 3/9/09 (beginning of bull market): 677
S&P 500 now: 1167 Change since 3/9/09: +72%

3. Indicators in Detail

• Conference Board Index of Leading Economic Indicators: The most recent report (September 23) showed an increase in this index, the second in a row. I require three straight monthly increases or decreases to label this as positive or negative, so this indicator remains neutral. +5

• Fed Funds Rate: No change. With the Federal Funds rate near zero, this indicator remains positive. +10

• S&P 500 Market Valuation (P/E): Morningstar pegs the current P/E of the S&P 500 at 14.7, up from 13.7 last time, but still well within positive territory at any value below 17.4. +10

• Morningstar’s Market Valuation Graph. Morningstar’s proprietary market valuation graph is at 1.00, up from 0.96 last time and suggesting that the market is exactly at “fair value” right now. For our purposes, that means neutral. +5

• S&P 500 Short Term Technical Trend: This short-term technical indicator uses the two shorter simple moving averages (SMAs) of the S&P 500. The configuration (see the chart) is Index > 20-day > 50-day. That suggests rally mode, with the index “pulling up” the shorter SMA, which in turn is “pulling up” the longer SMA. Positive. +10

• S&P 500 Medium Term Technical Trend: The mid-term indicator remains ambiguous, as the 200-day SMA is still higher than the 50-day SMA. If (when) the 50-day crosses through and above the 200-day, that will be known as a “golden cross,’ which many consider to be one of the strongest technical indicators. Until then (if it happens), this indicator remains neutral. +5

• DJIA Short Term Technical Trend: This chart looks similar to the S&P 500 chart. Positive. +10

• DJIA Medium Term Technical Trend: On the Dow, the “golden cross” took place a few days ago. Positive. +10

• NASDAQ Short Term Technical Trend: The NASDAQ’s chart has the same configuration as the S&P’s for both trends. Positive. +10

• NASDAQ Medium Term Technical Trend: Neutral. +5

TOTAL POINTS: 80
NEW READING: 80 / 10 = 8.0 = POSITIVE

September Rally Pulls Timing Outlook Back To Positive, But Still Not Re-Entering Market

1. Summary

An early September rally has pulled the Timing Outlook back into positive territory, up to 6.0 this time from a negative 4.5 last time.

For over four months, the S&P 500 has been stuck in a trading range of 1040 to 1130. The Timing Outlook has not performed well during this period, as the market’s drifts up and down have been timed nearly perfectly to repeatedly reverse the Timing Outlook, which I re-compute about every other week. So the Timing Outlook has been out of phase with the market’s short-term “trends.” There has been no long-term trend up or down; it has been sideways.

While the short drifts up and down have been long enough to keep the Timing Outlook off balance, they have been too short to pass my other criteria for being invested in stocks, so my Capital Gains Portfolio has been 100% cash since early May. The additional criteria, again, are:

• 9% rise over two weeks, with at least 7/10 days positive
• 3% rise over 3 weeks, with at least 10/15 days positive
• 4% rise over 4 weeks, with at least 14/20 days positive
• 5% rise over 5 weeks, with at least 17/25 days positive
• Etc.

The criteria are close to being met. Check out the chart above (click on it to enlarge it). It shows that the S&P 500 has risen about 6% during the past 10 trading sessions, with 8 of the past 10 sessions being positive. If the market’s rally continues a few more days, the criteria go to the three-week line, requiring a 3% rise with 10 out of 15 days being positive. We’re almost there. But patience is the watch-word. Don’t plug in hope as a substitute for actual performance. Waiting for the right entry point can be tedious, but avoiding losses is as important to overall success in investing for capital appreciation as scoring gains.

My Dividend Portfolio remains 100% invested after the changes described last time. By the way, I have begun to work on the 2011 edition of The Top 40 Dividend Stocks. I will keep you up to date on its progress. I hope to release it in January.

2. Market Performance Since Last Outlook
(“now” figures are as mid-day, Monday, September 13, 2010)

Last Outlook (8/25/10): 4.5 (negative)
S&P 500 last time (8/25/10): 1048
S&P 500 now: 1122 Change: +7%

S&P 500 at beginning of 2010: 1115
S&P 500 now: 1122 Change in 2010: +1%

S&P 500 at close 3/9/09 (beginning of bull market): 677
S&P 500 now: 1122 Change since 3/9/09: +66%

3. Indicators in Detail

• Conference Board Index of Leading Economic Indicators: No new report since last time. This index has been gyrating the past few months, rendering it ambiguous for our purposes. I require three straight monthly increases or decreases to label this as positive or negative. Indicator remains neutral. +5

• Fed Funds Rate: No change. With the Federal Funds rate near zero, this indicator remains positive. +10

• S&P 500 Market Valuation (P/E): Morningstar pegs the current P/E of the S&P 500 at 13.7, down from 15.2 last time. This indicator is in positive territory at any value below 17.4. +10

• Morningstar’s Market Valuation Graph: Morningstar’s proprietary market valuation graph is at 0.96, up from 0.91 last time. It is still in the neutral range, which is any value between 0.90 and 1.10. +5

• S&P 500 Short Term Technical Trend: This short-term technical indicator uses the two shorter simple moving averages (SMAs) of the S&P 500. The configuration (see the blue and green lines on the chart) is Index > 50-day > 20-day. That is ambiguous, reflecting the back-and-forth nature of the market over the past several months. Neutral. +5

• S&P 500 Medium Term Technical Trend: The mid-term indicator uses the two longer SMAs (50-day and 200-day, the blue and red lines on the chart). The lineup is Index > 200-day > 50-day. The recent 2-week rally has flipped this from last time, moving the indicator from negative to neutral. +5

• DJIA Short Term Technical Trend: This chart looks similar to the S&P 500 chart. Neutral. +5

• DJIA Medium Term Technical Trend: Same as the S&P 500. Neutral. +5

• NASDAQ Short Term Technical Trend: The NASDAQ’s chart has the same configuration as the other two. Neutral. +5

• NASDAQ Medium Term Technical Trend: Same as the other two. Neutral. +5

TOTAL POINTS: 60
NEW READING: 60 / 10 = 6.0 = POSITIVE

Buffett May Not Pay Dividends, But He Sure Likes Them

Berkshire Hathaway (BRK), aka Warren Buffett, has paid only one dividend since Buffett gained control. In 1967, Berkshire paid a dividend of 10 cents on its shares. It’s never happened again. Buffett has said he "must have been in the bathroom when the dividend was declared.”

Berkshire Hathaway is famous for not paying dividends despite having billions of dollars in cash. The company has many critics who believe that the company should “reward” or “return money to” shareholders. I am not one of those critics. I believe that Bershire/Buffett has proved itself to be perhaps the best allocator of capital on the planet, and I do not question that they can allocate their capital as well as or better than I could if they gave me some of it. I love dividends, but I don’t think Berkshire should pay a dividend.

Berkshire, while known mainly as an insurance company, is actually a conglomerate. It has a dizzying array of wholly owned companies in businesses as diverse as railroads, carpeting, candy, furniture, and jewelry. It also owns huge stakes in several public companies. It is the latter that I want to focus on, because Berkshire/Buffett has shown a great liking for companies that pay dividends.
Berkshire’s stock holdings are published quarterly. For the most recent quarter (ending June 30), here are its largest holdings, the percent of Berkshire’s stock portfolio represented by that holding, and the stock’s projected yield based on current payout. All information is from Morningstar.

• Coca-Cola (KO), 22%, yield = 3.2%
• Wells Fargo (WFC), 18%, yield = 0.9%
• American Express (AXP), 13%, yield = 1.8%
• Procter & Gamble (PG), 10%, yield = 3.3%
• Kraft (KFT), 6%, yield = 3.9%
• Johnson & Johnson (JNJ), 5%, yield = 3.8%
• Wal-Mart (WMT), 4%, yield = 2.4%
• Wesco Financial (WSC), 4%, yield = 0.5%
• U. S. Bancorp (USB), 3%, yield = 1.0%
• ConocoPhillips (COP), 3%, yield = 4.2%

These top 10 holdings account for 88% of all of Berkshire’s stock holdings—a very concentrated portfolio, especially considering its size. Overall, the company owns more than $46 billion in stocks, spread out over 37 different positions. (These figures do not include foreign investments held abroad.)

In Q2, Berkshire purchased about 17 million shares of Johnson & Johnson, adding to the 24 million it already owned. The total spent was about $1 billion, or about $58 per share. This was the biggest increase in any holding in Berkshire’s portfolio, raising its stake by 70%. What’s that worth in dividends? In June, J&J raised its dividend from $0.49 per share per quarter to $0.54, or $2.16 per year. A year’s worth of dividends at that rate for 24 million shares is $51,840,000. Actually, Berkshire will get more than that in the next 12 months, because J&J will raise its dividend again next June, as it has for 48 straight years.

In fact, 5 of those 10 companies are Dividend Champions—companies that have increased their payouts for 25 years or more consecutively: Procter & Gamble (54 years), Coca-Cola (48), J&J (48), Wesco (38), and Wal-Mart (36). ConocoPhillips has a 10-year streak going. In Q2, the second-largest increase in shares held by Berkshire was in Becton Dickinson (BDX), in which Berkshire increased its position by 8%. Becton Dickinson is a Dividend Champion with a 37-year streak.

Charlie Munger, Buffett’s sidekick at Berkshire, has been quoted as saying, “Investing is where you find a few great companies and then sit on your ass." While dividend-raising companies require attention just as any stock holdings do, it is clear that Berkshire/Buffett have found several great companies with a common characteristic—they pay consistently rising dividends. They have helped make Buffett the richest investor in the world.

Portfolio Forensics

From time to time, one runs across pointless arguments about whether buy-and-hold is dead. Most long-term stock holders know that buy-and-hold really means buy-and-monitor, or buy-and-homework, or some similar phrase that indicates that reasons can arise to sell a long-term holding. The days of the dying grandfather telling his family “Never sell the AT&T” are long gone. While the ideal might be to hold each stock “forever,” life happens, and in doing so it can create reasons to sell any stock.

How do you decide? I advocate periodic Portfolio Reviews. In my Dividend Portfolio, which is devoted to dividend growth stocks and does not require real close attention, I aim to conduct a review twice per year. The point is to impose upon yourself the discipline to really examine your stock portfolio periodically, apply standards designed to reveal whether each stock still deserves a place in your portfolio, and take action on what you find out.

In my Dividend Portfolio, normally the presumption is that each dividend stock will not be sold. But that presumption can be overcome. During a Portfolio Review, the burden shifts to the company to prove why it should be kept. Here are some of the questions I ask:

• What is its yield on cost (YOC)? I don’t penalize a dividend growth stock solely because its current yield may have dropped below qualifying levels. That may be only because the stock’s price has jumped way up. If I purchased it years ago, and I am still satisfied with how it is growing its dividend, the reliability of the dividend, etc., I normally would keep it. It is doing its job. By the way, the formula for YOC is: Yield on Cost = (Current Yield x Current Price) / Acquisition Price. An equivalent formula is Last 12 Months’ Dividends / Acquisition Price.

• Should some profits be taken? If the company’s price has skyrocketed, that may present an opportunity to cash out some or all of it and purchase another stock selling at a better price and offering a higher yield. The goal would be to have the total dividend stream increase after the transactions are completed. Notice that if you have held a stock a long time, its current yield may be low but its YOC may be quite high, difficult to match with a new purchase.

• Is the safety of its dividend in question? As soon as BP’s oil rig blew up, the safety of its dividend became perilous for anyone who thought about it. In a Portfolio Review, update your information on each company and give serious thought to the ongoing reliability of its dividend.

• Is there a chance to improve your portfolio by making a stock swap? There are various ways to improve your portfolio, such as increasing its total yield, increasing the rate of dividend growth, diversifying it, and so on. As to increasing yield, note the discussion above (second bullet) about making sure that the initial yield on a new purchase would exceed the YOC of the stock you would sell. If it wouldn’t, it’s hard to justify the swap. A higher expected rate of increase may tip the scales.

• Did the company cut or freeze its dividend? If so, it is subject to immediate examination. You will probably decide to sell most stocks that cut or freeze their dividend. The main goal of my Dividend Portfolio is to deliver an ever-increasing dividend stream, so obviously a cut or freeze hurts that goal. Also, a cut or freeze often portends a price drop. Confident management teams adhere to established dividend-growth patterns. A company that cuts or freezes its dividend is conserving cash for some reason. Find out why. The company may be in difficulty, and its price may be in for a drop too. Selling early usually brings in the most money you will be able to get for that stock for a long time to come.

• Has the company’s current yield risen above 10 percent? If so, it is subject to immediate review, but this is not an automatic reason to sell. An extremely high yield is usually the result of an extremely low price. Find out why the market has devalued the stock. It may be a clue that the company is having major problems, and upon examination you may discover that the dividend itself is in peril. This may be dividends’ equivalent of a “dead-cat bounce” in price.

• Has the rate of growth of the dividend taken a turn for the worse? Can you figure out why? Many dividend investors regard dividend growth as a key indicator of future prospects, because it reflects management’s view of and confidence in the next few years, often based upon information available to them but not to you.

Let’s look at some examples. Here is how these principles played out for six stocks in a recent Portfolio Review of my Dividend Portfolio.

Abbott Labs (ABT): I own two slugs, purchased in 2008 and 2009. Their yields on cost are 3.2% and 3.7%, respectively. Abbott increased its dividend 10% this year. The stock is working fine. Decision: Hold

Alliant Energy (LNT): Initiated position early in 2010, and it has worked out well. The stock has a 9% price increase and a 4.9% YOC after a 5% dividend hike this year. Decision: Hold.

Diageo (DEO): I bought this in 2008. Diageo is a foreign stock (Britain), and like many foreign stocks, it does not adhere to a predictable dividend-raising schedule. It makes two payments per year, and the first payment is typically less than the second payment, making the total year’s dividend impossible to predict. In its native currency, Diageo has been a steady dividend raiser, but with varying exchange rates, that has sometimes translated into fewer $US, as if it had cut its dividend. Too many headaches to keep track of, despite the company’s strengths. My position was small, and I had a 14% long-term price gain on the stock. Decision: Sell and put the money to work elsewhere.

Emerson Electric (EMR): Also purchased in 2008, EMR has disappointed lately with small dividend increases, just 2% in 2010. Its 2.7% yield on cost (YOC) was pulling the portfolio’s YOC down. Last year, I put it on sort of probation, sticking a 10% trailing sell-stop under it. It survived by steadily moving up in price from what had been a significant capital loss. After nearly hitting the breakeven point, its price began to weaken again. The lousy dividend increase motivated me to put a tighter stop under it (5%), which it hit a couple of weeks later. Decision: Put tight stop under it; the stop was hit, so stock sold.

McDonalds (MCD): Purchased in 2008 and again in 2009. YOC is 3.7% and 4.1% respectively. Blended price increase is more than 20%. Raised its dividend 26% in 2009; awaiting 2010’s increase (which typically comes with the final payment of the year). What’s not to like? Decision: Hold.

Royal Bank of Canada (RY): Purchased in 2008, the stock survived the financial crisis and is a solid, stable bank. But it has not increased its dividend since 2008. I decided to put this small position’s money to work elsewhere. Decision: Sell.

The Dividend Portfolio contained 12 stocks when I did the Portfolio Review. The 3 sells mentioned above are a little misleading, because I wanted to show examples of reasons to sell. Those were the only 3 sales resulting from this review. The other 9 stocks were held. In dollar terms, there is typically less than 10% turnover per year in this portfolio. Sometimes there is none.

A good practice is to keep a Shopping List ready—stocks that will help improve your portfolio in some way and that meet all your criteria for buying a stock. For my Dividend Portfolio, I use my e-book, The Top 40 Dividend Stocks for 2010, as my Shopping List. I make sure to update the information, especially any target’s yield and valuation, before making any purchase. With the proceeds from the 2 immediate sales, I increased my stake in Alliant Energy. At a current yield of 4.5%, that gave a nice boost to the portfolio’s overall YOC (which was 4.1%). When Emerson Electric hit its sell-stop, I used those proceeds to initiate a position in Johnson & Johnson (JNJ), whose price seems depressed, at a 3.6% initial yield. I was pleased to see that Warrren Buffett—through Berkshire Hathaway (BRK)—had made JNJ his single largest stock purchase in Q2, adding 17 million shares to the 24 million he already owned, spending about $1 billion on the purchase. I picked up 50 shares myself. What the hell. Always glad to be in agreement with Mr. Buffett.

August's Market Swoon Pulls Timing Outlook Back To Negative

1. Summary

After the stock market’s rally in July, which pulled the Timing Outlook up into positive territory, August has seen a nearly equal but opposite slide. Today’s Timing Outlook is negative at 4.5, significantly down from 7.5 last time. Today’s S&P 500 value (at mid-day) of about 1048, is a value that has been crossed through several times in the last few months as the market see-saws up and down. In other words, the market has overall been sideways for three months, but with significant volatility that has looked like trend-starts, but turned out to be false hopes.

This kind of yo-yo action causes the Timing Outlook to jump around too. The last five readings, including today’s, have been Negative-Positive-Negative-Negative-Positive-Negative. Short-term (2-3 week) market reversals are the worst conditions for discerning an investable trend. The Timing Outlook is least useful under these conditions, as swings to-and-fro with the market.

My Capital Appreciation Portfolio has remained 100% in cash since early May. That means that it has gained nothing, but in so doing it has outperformed the S&P 500, which has an overall loss since that time. In the last report, the July rally led me to review the criteria for re-entering the market.

• 9% rise over two weeks, with at least 7/10 days positive
• 3% rise over 3 weeks, with at least 10/15 days positive
• 4% rise over 4 weeks, with at least 14/20 days positive
• Etc.

The market’s August drop has put these criteria out of reach again, at least for a while. It is hard to see the catalyst that would trigger a sustained rally. Q2 earnings came in strong: 66% of companies in the S&P 500 beat earnings estimates, and 63% beat revenue estimates. But that good news has been offset by poor economic news. Corporations are doing well, but individuals are not. It seems that every day, some negative report is issued about housing, manufacturing, unemployment, a “jobless recovery,” troubles in Europe, the possibility of a double-dip recession, or the possibility that we’ve never actually exited the Great Recession. Ben Bernanke stated recently that the economy is displaying “unusual uncertainty.” Traditionally, markets hate uncertainty.

My Dividend Portfolio is 100% invested, but I made some changes this month. I completed a Portfolio Review, which led me to sell three stocks (Diageo, Emerson Electric, and Royal Bank of Canada) and replace them with two others (added to position in Alliant Energy and initiated position in Johnson & Johnson). These are the first changes to the portfolio in a year. Hopefully they will strengthen the portfolio for its key objective: To generate ever-increasing income streams. The holdings in the Dividend Portfolio are not protected by sell stops. Risk management is accomplished by means of the Portfolio Reviews.

2. Market Performance Since Last Outlook
(“now” figures are as mid-day, Wednesday, August 25, 2010)

Last Outlook (8/5/10): 7.5 (positive)

S&P 500 last time (8/5/10): 1126
S&P 500 now: 1048 Change: -7%

S&P 500 at beginning of 2010: 1115
S&P 500 now: 1048 Change in 2010: -6%

S&P 500 at close 3/9/09 (beginning of bull market): 677
S&P 500 now: 1048 Change since 3/9/09: +55%

3. Indicators in Detail

• Conference Board Index of Leading Economic Indicators: The most recent report last week showed a tiny increase in this index. The index has been gyrating the past few months (displaying “unusual uncertainty” too, I guess), rendering it ambiguous. I require three straight monthly increases or decreases to label this as positive or negative. Indicator remains neutral. +5

• Fed Funds Rate: No change. The Fed continues to reinforce the idea that rates will not be raised anytime soon. In a nutshell, they seem to see “unusual uncertainty” in the economic recovery combined with little possibility for inflation in the next few months. With the Federal Funds rate near zero, this indicator remains positive. +10

• S&P 500 Market Valuation (P/E): Morningstar pegs the current P/E of the S&P 500 at 15.2, same as last time. This indicator stays in positive territory at any value below 17.4. +10

• Morningstar’s Market Valuation Graph. Morningstar’s proprietary market valuation graph is at 0.91, down significantly from 0.98 last time and close to the 0.90 level that would move this indicator into positive territory. For now, the indicator remains in the neutral range, which is any value between 0.90 and 1.10. +5

• S&P 500 Short Term Technical Trend: This short-term technical indicator uses the two shorter simple moving averages (SMAs). The configuration is 20-day > 50-day > Index. That is ambiguous, reflecting the yo-yoing in the market. Neutral. +5

• S&P 500 Medium Term Technical Trend: The mid-term indicator uses the two longer SMAs (50-day and 200-day). The lineup is 200-day > 50-day > Index. This is exactly the opposite of an uptrend. Negative. +0

• DJIA Short Term Technical Trend: This chart looks similar to the S&P 500 chart. Neutral. +5

• DJIA Medium Term Technical Trend: Same as the S&P 500. Negative. +0

• NASDAQ Short Term Technical Trend: The NASDAQ’s chart has the same configuration as the other two. Neutral. +5

• NASDAQ Medium Term Technical Trend: Same as the other two. Negative. +0

TOTAL POINTS: 45
NEW READING: 45 / 10 = 4.5 = NEGATIVE

Financing Retirement V: The Cistern Model

This is the final article in my series on retirement.

Essentially all strategies for financing retirement—even those as philosophically opposed as maximizing capital vs. maximizing income rights—use the same “plumbing.” I like to think of it in terms of cisterns, with pipes running in and out, and leaks. The idea comes from those old algebra questions where A could fill his cistern at a certain rate, B’s cistern filled more slowly and also had a leak in it, and poor C’s cistern was a veritable symphony of problems. As a 12-year-old, you had to create formulas to figure out how long the water in each cistern would last. See Stephen Leacock’s hilarious short story, “A, B, and C—The Human Element in Mathematics.” (For younger readers: A cistern is a big barrel to collect rainwater.)

Here’s the analogy: Your retirement assets are in the cistern. There are two goals:

          · The cistern must fund your retirement adequately.
          · The cistern must never go empty. In fact, it must never get even close enough to empty that you worry about it or lose sleep over the possibility. You want a nice, abundant cistern that inspires confidence.

There is continual change in your cistern. It is not a static thing, which is why I prefer this analogy to the more common “nest egg.” The cistern’s contents expand and contract throughout your life, both before you retire (the so-called accumulation years) and after you retire (the decumulation years).

What goes into your cistern? Mostly assets that you decide to put in there. Some inflows to your retirement cistern begin early in life, while others come along later. Typical inflows include savings, 401(k) contributions, dividends, royalties, Social Security, pensions, interest, inheritances, etc.

Note that I count as inflows some items (such as Social Security) that a retiree may just spend directly. I will explain why I do this in a minute. Note also that, with the exception of old-fashioned pensions and Social Security, inflows require a positive decision on your part. You must decide to put assets into your cistern (or not).

Besides expanding from the contributions that you make into your cistern, the level in your cistern also goes up when you experience increases in the market value of assets already there. Examples of assets that may enjoy value expansion include:

          · Stocks, ETFs, mutual funds, and the like
          · Your house
          · Increasing dividends from companies that raise dividends regularly
          · A small business you may own

What about declines? It is important to note that declines in the level of the assets in your retirement cistern take place not only after retirement via actual withdrawals, but earlier in life as well. Some people “raid” their cistern prior to retirement to cope with emergencies or to make large purchases. Taking out a home equity loan to buy a boat, for example, decreases the level of your cistern in two ways: First, the value of the loan lowers your equity in your home and thus decreases its value in your cistern. Second, the additional debt creates interest obligations that reduce the amount you can put into your cistern for some time into the future.

The level in your cistern also goes down if the value of the assets in it declines. Significant declines in the value of your stocks or your home obviously can have a major impact on the level in your cistern. During the recent financial crisis, some people have been forced to delay long-planned retirements, because the levels in their cisterns went down so far that the two major goals—seemingly within their grasp—suddenly were moved out of reach.

And everybody’s cistern has a leak: Inflation. That is a continuing outflow, sometimes rapid, sometimes slow, that insidiously reduces the value of the contents of your cistern. Only if we go into a period of deflation would the value-of-money dynamic actually cause the value of what’s in your cistern to expand. It would become like an inflow rather than a leak.

I said that I would explain why I count as inflows monies that go directly to spending, such as Social Security payments. The reason is that if we visualize that everything runs through the cistern, even if only briefly, it puts all assets on an equal footing for analysis. The value of income rights can be directly compared to the value of capital, for example.

Viewed this way, everyone makes withdrawals from their cisterns. Thus, someone who spends his Social Security check upon arrival must acknowledge that if he did not spend all of it, he could deposit the balance in his cistern for a future day. And the debate between income-maximizing strategies and capital-maximizing strategies can be seen for what it really is, which is an assessment of two strategies, both of whose goals are the goals stated at the beginning of this article. In both cases, the retirees are betting that their strategy will both provide sufficiently for retirement and that their cistern will never run dry.

Say someone maximizes income during their accumulation years by loading up on dividend-paying stocks, then lives off the income in retirement. We can picture the dividends as flowing into the cistern through a dividend pipe, but flowing right back out through a dividend-withdrawal pipe. Such a person might say that she is not making “withdrawals” if they just take the dividends directly, but she really is, because if not taken immediately as cash, the money would flow into the cistern. The same reasoning applies to pension or Social Security income. You may take it directly, but it is helpful to view it as flowing into and out of the cistern. It provides a better picture of the dynamics of retirement funding.

Similarly, someone who loads up on growth stocks during their accumulation years, then converts those assets into income by selling portions to fund retirement, is clearly making withdrawals. The “bet” is whether the unsold assets remaining in the cistern will simultaneously expand enough to make up for the assets sold. Similar reasoning applies to someone who buys an annuity: She makes a big withdrawal to buy the annuity, but the annuity itself then creates an inflow of income that lasts the rest of her life. The “bet” is whether the income will eventually exceed what it cost to purchase the annuity.

So the cistern analogy is strategy-neutral. I believe that viewing retirement funding in this way allows for more reasoned comparisons of strategies. It’s no secret that I believe in the efficacy of accumulating assets that bear rights to receive increasing dividends, and that I think that it is a superior retirement strategy to relying principally on accumulating assets that hopefully will expand in value via increasing prices to offset withdrawals. But I do not kid myself that when I spend those incoming dividends or Social Security checks, I am not really draining a little bit out of my cistern each time too.

July Rally Yanks Timing Outlook Into Positive Territory; Time to Wade Back In?

1. Summary

The stock market rallied strongly in July, although not a straight-line fashion. The market’s volatility continues to have the Timing Outlook jumping around too. The last five readings have been negative-positive-negative-negative-positive. Today’s value is positive at 7.5, significantly better than 4.5 last time.

To repeat a message from the last several Timing Outlooks: The Timing Outlook is least useful when the market is gyrating, as it is pretty sensitive to short-term (2 to 3-week) market moves. Despite the strong (if choppy) July, we have been in a volatile market since mid-April. If U means up and D means down, the weekly market changes since mid-April have been D-U-D-D-U-D-U-D-U-D-D-U-U-U-D. This week is too soon to call.

(click on chart to enlarge it)

My Capital Appreciation Portfolio has remained 100% in cash since early May. With the July rally, let’s look at the criteria for re-entering the market. As noted in this article, I look for:

• 9% rise over two weeks, with at least 7/10 days positive
• 3% rise over 3 weeks, with at least 10/15 days positive
• 4% rise over 4 weeks, with at least 14/20 days positive
• 5% rise over 5 weeks, with at least 17/25 days positive
• Etc.

An astute reader has pointed out that I actually overlooked a “Buy” signal in early July. As of the close today (Thursday), we are just short of 3-week and 4-week “Buy” signals. The percentage increases are sufficient, but the number of positive trading days falls 1-2 short in each case. I will be watching the trading ranges more closely, and if a “Buy” signal comes along, I will re-enter the market with a portion of the portfolio’s cash, with any purchase protected by a sell stop.

Subjectively, this is a hard market to have confidence in. Q2 earnings reports are coming in strong, but economic factors and the general “feel” of things does not inspire confidence. Nevertheless, if the criteria generate another “Buy” signal, I will be buying. Gotta go with the system.

As usual, my Dividend Portfolio remains 100% invested. While its value has been dancing along with the market, its main goal—generating ever-increasing income streams—is still being met. None of the stocks in the portfolio has cut or frozen its dividend this year. Many have raised their dividends. The holdings are not protected by sell stops.

2. Market Performance Since Last Outlook
(“now” figures are as of close Thursday, August 5, 2010)

Last Outlook (7/19/10): 4.5 (negative)

S&P 500 last time (7/19/10): 1071
S&P 500 now: 1126 Change: +5%

S&P 500 at beginning of 2010: 1115
S&P 500 now: 1126 Change in 2010: +1%

S&P 500 at close 3/9/09 (beginning of bull market): 677
S&P 500 now: 1126 Change since 3/9/09: 66+%

3. Indicators in Detail

• Conference Board Index of Leading Economic Indicators: The most recent report showed a decline in this index. The index has had a couple of declines in the past few months, rendering it ambiguous. I require three straight monthly increases or decreases to label this as positive or negative. Indicator remains neutral. +5

• Fed Funds Rate: No change. The Fed and people speaking for it continue to reinforce the idea that rates will not be raised anytime soon. With the Federal Funds rate near zero, this indicator remains positive. +10

• S&P 500 Market Valuation (P/E): Morningstar shows the current P/E of the S&P 500 is 15.2, up from 14.3 last time. This indicator stays in positive territory at any value below 17.4. +10

• Morningstar’s Market Valuation Graph. Morningstar’s proprietary market valuation graph is at 0.98, up from 0.93 last time. That keeps this indicator in the neutral range, which is any value between 0.90 and 1.10. +5

• S&P 500 Short Term Technical Trend: The market has rallied, in fits and starts, since the beginning of July. It has now reclaimed the value it had in early June. This short-term technical indicator uses the two shorter SMAs. The configuration is Index > 20-day > 50-day. That is the best configuration to indicate a rising market. Positive. +10

• S&P 500 Medium Term Technical Trend: The mid-term indicator uses the two longer SMAs (50-day and 200-day). The lineup is Index > 200-day > 50-day. This is an ambiguous configuration. Neutral. +5

• DJIA Short Term Technical Trend: This chart looks basically like the S&P 500 chart. Positive. +10

• DJIA Medium Term Technical Trend: Same as the S&P 500. Neutral. +5

• NASDAQ Short Term Technical Trend: The NASDAQ’s chart has the same configuration as the other two. Positive. +10

• NASDAQ Medium Term Technical Trend: Same as the other two. Neutral. +5

TOTAL POINTS: 75
NEW READING: 75 / 10 = 7.5 = POSITIVE

Financing Retirement IV: Asset Allocation

In the previous article in this series (immediately below this one), I stated that in conventional retirement planning, there are three critical steps:

• Maximize your capital before you retire.
• Make your capital a lot “safer” as you approach retirement.
• In retirement, withdraw capital at a “safe” rate, typically figured to be 4% in the first year, then raised each year by 3% to account for inflation. That withdrawal converts what was capital into retirement income by the process of selling assets.

Coincidentally, AAII Journal ran two articles in their July, 2010 issue that address all three of those bullet points. Or I should say that it mentions them—they took all three bullet points above and used them as unquestioned truisms. From this foundation, they built two entirely contradictory models for asset allocation before, at, and after retirement.

Under Modern Portfolio Theory (MPT), it is said that proper asset allocation insulates your entire portfolio from the ups and downs of one single class of securities. It is commonly accepted that your selection of individual securities is secondary to the proportions in which you allocate your investments in stocks, bonds, and cash. I believe that the rule of thumb is that 70% of your investment results will come from asset allocation, not from what securities you pick.

Asset allocation for retirement is a hot topic. On June 18, The Department of Labor and SEC held a joint hearing related to target date funds, many of which underperformed the S&P 500 in 2008-09. Target date funds have rapidly gained popularity since they were introduced in 1996. At the moment there are nearly 300 of them, with $176 Billion in assets. Their attraction is that, once you designate your retirement date, they offer the automatic achievement of the first two bullet points above.

• They maximize your capital via diversification and an ideal stock/bond ratio while you are in the accumulation years of your life. Investors with different risk profiles can select from among funds that are more or less aggressive. “Aggressiveness” is always equated with what percentage of stocks the fund contains. At a young age, the most aggressive fund may contain 90% or more stocks. Even at retirement, an aggressive fund may still contain 75% stocks.
• They make your nest egg safer as retirement approaches by automatically shifting from equities to bonds as you grow older, theoretically arriving at a perfect mix just in time for your retirement. “Safety” is always equated with holding more bonds and fewer equities.

When the market crashed in 2008-09, some of these target-date funds looked very inept. Losses were more severe than they should have been, especially for “I’m nearly retired” funds with short-term horizons. Either many of them did not keep the promise of shifting to bonds, or they did not do it fast enough, or it just plain did not work. “Target date funds have produced some troubling investment results,” said SEC Chairman Mary Schapiro in a June 2 speech before the subcommittee on Financial Services. “[The] varying strategies among these funds produced widely varying results. Returns of 2010 target date funds ranged from minus 3.6 % to minus 41%.” Obviously, retirees who lost 41% of their nest eggs in 2008-09, when they were expecting to retire in 2010, were catastrophically affected--especially when the third step of conventional retirement practice, namely selling off some of your nest egg each year, came into play.

In MPT, the hypothesis is that stocks are riskier than bonds, but that they hold the promise of better long-term returns. As the AAII says in its beginning investor series, “Stocks are more volatile than bonds, but have historically provided higher long-term returns.” Historical data supports this. It is hard to find a 30-year period, ever, that stocks have not outperformed bonds. But at shorter timeframes, stocks are considered riskier because of their price volatility. Thus the conventional wisdom is that the way to make your portfolio safer as you approach (or are in) retirement is by switching from stocks to bonds in your overall allocation.

As I stated in the last article, the problem I have with that thinking is that (1) it presumes that all retirement income will come from selling off assets, and (2) it ignores the fact that some stocks generate income themselves.

In the two AAII articles, there is not a single mention of dividend stocks as a separate asset class that may have different risk characteristics from all stocks as a class or bonds as a class. There is not even a suggestion that they might form a different category of stocks. The omission is puzzling, because stocks are traditionally sliced and diced into so many categories that supposedly offer different risk/reward profiles within the broad classification of “stocks.” Thus you get categories like U.S. Large-cap, Mid-cap, Small-cap; Foreign stocks, often nowadays themselves divided by size, country or region of the globe; Emerging markets; Value vs. Growth; and so on. But the simplest, most obvious categorization of all—do they pay a dividend?—is ignored.

It’s an important distinction. Dividend-paying stocks tend to move less (in both directions) than the market, meaning that they have a different risk/reward profile. Their dividends yield positive income even when their prices are falling. The companies that raise their dividends regularly tend to keep doing so even when the market as a whole is falling. The dividends themselves, being always positive (there is no such thing as a negative dividend), change the risk/reward profile. And studies show that the best overall returns come from dividend-raising stocks.

So the question begs to be asked: If the goal of a retirement nest egg is to provide its owner with sufficient income in retirement, and some stocks provide rising income streams by their very nature without the necessity of selling them, then why are those facts ignored in conventional retirement planning? Why are they ignored in asset allocation discussions?

It is certainly a paradigm shift to think of dividend stocks as a separate asset class, but for purposes of this article, that’s just what I am going to do. Here’s why: Traditional methods of classifying assets divide them into three major realms: Stocks, bonds, and cash. Stocks are evaluated on their prices; and bonds are evaluated on their yields. But dividend stocks have both characteristics: Their prices vary (but in a more muted fashion) with stocks generally. And their yields provide income, but with a growth kicker that most bonds don’t have—dividend-growth stocks are rising income instruments rather than fixed income investments. (In some texts, you will see the phrase “fixed-income investment” used interchangeably with “bond.”)

It’s almost like MPT has a huge hole in it. It does not miss the obvious income-producing ability of bonds—after all, that’s what a bond is, a debt instrument. The income it produces is interest on the money lent. MPT does not miss the price-appreciation potential of stocks, nor the short-term volatility they have displayed over the years. So why does MPT miss the income-producing ability of dividend stocks, the rising income-producing ability of habitual dividend-raisers like the Dividend Champions, or the muted price volatility that is characteristic of dividend stocks?

I cannot answer that question. But my conclusion is that for those who get it, dividend stocks, especially dividend-growth stocks, should not be lumped in with all stocks when it comes to making asset allocation decisions. A retiree’s portfolio can safely contain a higher percentage of dividend stocks than is normally associated with the low level of risk tolerance of a retiree. And the reason that is true is precisely because the dividend stocks throw off a continuing income stream and do not have to be sold to produce retirement income. Thus, maintaining a fairly high percentage of your retirement portfolio in well-selected dividend stocks is not too aggressive or risky for a retiree. It is safer.

Financing Retirement III: Turning Capital Into Income

This is the third article in a series on financing retirement as seen by someone who is retired (me). It’s a view from the front lines. It is pragmatic, not academic.

To recap the first two articles:

• In “Thoughts on Financing Retirement I--Beware Rules of Thumb,” I made the point that in retirement, you need to generate the income needed to cover your expenses. There are many ways to generate income—consulting, part-time work, Social Security, pensions—that may be overlooked in conventional retirement planning. Of course, income from your assets is an important ingredient in the recipe.

• In “Financing Retirement II: What’s Your Number?,” I criticized the “maximize capital” approach to retirement planning, noting that the “number” to focus on is not the capital value of your nest egg, but rather its annual income-generating ability. The two are often assumed to be proportional, but they are not. I used myself as an example, noting that according to conventional calculators, I was years and more than $1,000,000 from being able to retire, whereas in fact I have been retired for almost 9 years and live comfortably.

In this article, I want to focus on that disconnect. I believe that it comes down to how capital in a nest egg becomes income in retirement. I will be careful here in my use of the word “assets.” It is tempting to use “assets” and “capital” interchangeably. But to do so is misleading, because it assumes that the only value of an asset lies in its price if sold, and thus that the only measure of its value is its price. That notion is incorrect.

In conventional retirement planning, there are three critical steps:

• Maximize your capital before you retire.
• Make your capital a lot safer as you approach retirement.
• In retirement, withdraw capital at a “safe” rate, typically figured to be 4% in the first year, then raised each year by 3% to account for inflation. That withdrawal converts what was capital into retirement income by the process of selling assets.

The problem I have with that thinking is this: It ignores the fact that some assets generate income themselves. They do not have to be sold to produce income. A few examples of such assets are:

• Pensions
• Social Security
• Annuities
• Bonds
• Dividend stocks

That is why it is important to distinguish assets from capital. The first two items above are not capital at all, but they generate income. They are truly assets: They are rights that you have acquired to receive income. If you have a pension, you earned it over time from your employer. You earned your right to Social Security payments in the same way, by working and contributing (along with your employer) to the system.

The last three items, on the other hand, are investments purchased with capital. Once purchased, they confer an important right: The right to receive an income stream.

• Annuities allow you to purchase that right from an insurance company for a price and fees that depend on your age, gender, the payout system you choose, etc. You never get your capital back, you trade it for the right to receive income for the rest of your life. (There is a useful annuity calculator at Immediate Annuities.com.) Assuming that the insurance company remains solvent, your right to the income is totally safe, except from inflation. The price you paid is totally gone.

• Bonds are also purchased with capital. Let’s assume that you invest only in “investment grade” bonds and hold them for income. The income they generate is as safe as with annuities. Instead of being for life, your right has a term limit stated on the bond, which is a contract of debt (you loaned your money to the bond issuer). Being fixed, the income stream is not safe from inflation. The capital you purchased the bonds with is safe in the sense that you will get it back at the end of the bond’s term, but its value will also have been eroded by inflation. So with investment-grade bonds, the income is safe, except from inflation. The principal is also safe, except from inflation.

• Stocks are also purchased with capital. Conventional wisdom is that they are far less safe than bonds, because their prices are volatile. Retirees who invested throughout their lifetimes mainly in stocks to maximize capital, and who then unfortunately suffer a significant loss in the value of their portfolio just before they reduced their stock exposure—because of, say, a bear market—are screwed. The income available from selling a percentage of their assets each year falls proportionately with their stock portfolio’s total price. Even after the stock exposure reduction, that percentage of your nest egg still in stocks is subject to the usual risks of the market.

But what if the stocks were well-selected—“investment grade”—dividend-growth stocks? Does the same misfortune happen? No.

• Dividend stocks generate income. Their value does not lie in their ability to be periodically sold off. Their true value lies in their ability to generate income on their own. In that respect, they are like bonds.

• But unlike bonds, dividend growth stocks are not fixed-income investments. Their yield on cost—which is comparable to the yield on bonds—goes up each time that they raise their dividend payout. They are rising-income investments. In fact, the income from investment-grade dividend growth stocks generally keeps up with or surpasses inflation.

• Unlike bonds, there is no term. Ideally, dividend-growth stocks can be held “forever.” You do not have to worry about the impact of inflation on your principal. An investment-grade dividend-growth stock whose price goes down does not necessarily reduce its dividend nor even stop increasing it. Scores of stocks have been raising their dividends for 25 to 50 years or more. They have done this since the Eisenhower administration, through every kind of economic condition—wars, recessions, inflation, stagflation. See the Dividend Champions document here that lists them.

• Finally, unlike bonds, over long periods of time, investment-grade dividend-growth stocks are likely to increase in principal value too. Every study that I have seen shows that dividend-growth stocks have the best total returns of all categories of stock.

Conventional wisdom is that a retiree’s stock-to-bond ratio should go way down as one approaches retirement age. The reason, of course, is that bonds are considered to be much safer than stocks. But are they? How do you weigh the safety of bonds’ principal and interest payments—both fixed and subject to the ravages of inflation—against dividend-growth stocks’ ability to raise their rate of return and potentially increase their principal value too? We are conditioned to think, when talking about safety, only of the principal (or capital) side of the equation. Subliminally, we fall into the “capital is everything” mind-set very easily.

But let’s raise that up to a conscious level and actually think about it. If you believe, as I do, that “it’s all about income” in retirement, then the safety we should be focused on is the safety of the income stream, including its safety from inflation.

Looking at dividend-growth stocks in this way is a paradigm shift. We are brought up and taught as investors to maximize that nest egg. But in retirement, it’s all about income. In a well-chosen ‘investment grade” dividend stock portfolio, very few stocks will fail to consistently increase their dividends each year. So the income stream goes up, in most years easily surpassing inflation. Even in bad dividend years for stocks generally (like 2009, when the total dividends paid out by the S&P 500 declined by billions), a portfolio of stocks chosen specifically for their dividend-raising prowess will throw off more dividends. I maintain a demonstration portfolio about this (see it at my Web site, Sensible Stocks.com), and in 2009, I received 19% more dividend dollars than in 2008.

Am I suggesting that conventional approaches to asset allocation in retirement—heavy on bonds, light on stocks—might be improved upon if the stocks in question are investment-grade dividend-growth stocks? Yes. And I am also suggesting that the income available for retirement from a portfolio that includes a heavy dose of excellent dividend stocks may exceed the income created by slicing off and selling a portion each year of a maximum-capital portfolio—even if the max-cap portfolio is significantly larger in size.

That may be why the retirement calculators tell me that I can’t retire until I accumulate $1,000,000 more—they don’t know about my dividend stocks. They didn’t ask.

In the real world, most retirees gather their income from a variety of sources. While the goal for dividend investors may be to live off of the dividends without selling off any of the base, the dividend stream may not be large enough. So some of the base—but far less than the “4% + inflation” standard—may be sold off to close gaps. There is an excellent recent article by Morningstar author Christine Benz that addresses how real retirees achieve the right balance: “Income or Total Return? Retired Investors Weigh In.” I highly recommend it.