Does the PP fail to take into account the benefits of Dividends?

[Bonafede]

So I was having a conversation the other day with a gentleman who works in the financial industry and we got to talking about the PP. We were both in agreement about the benefits of uncorrelated assets, and even the idea of having a PP versus a VP.

However, he brought up an interesting point about dividends I haven't considered about the PP. That is the benefits of dividends in planning for retirement can add substantial income to your portfolio. When we started discussing the PP and dividends, it is obvious that over half of the portfolio wouldn't offer any dividend income stream.

My first reaction to this thought is well the principal and capital gains on the PP would outweigh the dividends, right? Then he gave an example where protecting the base (as the PP does very well) may not really matter, as dividends are generally continued to pay out regardless of the NAV.

The example he mentioned in this case was with GE stock. Say you owned 1000 shares that were worth $1 M (pre 2008), and were yielding $40K in dividends annually. Well after the stock market 'adjustment', those shares value decreased to say $550K, but still continued to yield the $40K in dividends.

This was an interesting example, and I'm not sure I'm smart enough to really understand this as it relates to the PP. So, I pose the question to the forum....

[MediumTex]

25% of the PP provides no dividend, not half, as your friend suggested.  Right now, cash doesn't yield much, but over time cash tends to provide a yield around 200 basis points below what LT bonds are yielding (this fluctuates, of course).

GE is a great example of a different point than your friend was making.  After the 2008 crash I believe GE cut its dividend for the first time in the history of the company, so the falling price of the stock DID ultimately affect the dividend yield.

HB noted in his writings that a profit achieved through capital gains spends just as well as thoses achieved through dividends.

When having these discussions I think it's important to focus on the big picture, which is an average return of around 9% over 40 years, with a maximum drawdown of 2 or 3%.  To me, whether these returns were achieved through dividends, capital gains, or both is not that important.

[moda0306]

Because dividends can be adjusted at the company's will, and the price can adjust as a result, dividends really aren't that safe of a form of income.

A 30-year bond, however, actually has that interest written into a contract.

I think the man you spoke to is working within a set of parameters that is far too rose-colored.  Once you get outside the normal for any extended period, these dividends vs promises to pay from the government take on much different appearances than they do when things are rolling along just fine.

[MeDebtFree]

When having these discussions I think it's important to focus on the big picture, which is an average return of around 9% over 40 years, with a maximum drawdown of 2 or 3%.  To me, whether these returns were achieved through dividends, capital gains, or both is not that important.

It is MT's simple statement that sums up the entire issue (at least for me).  Regardless of all the discussion that takes place on this and other forums about all the possible slicing and dicing permutations for an HB PP, I always mentally go back to the most important parameters; 9% CAGR, low and infrequent draw down, long history, and sound fundamental reasoning underneath it all.  The simplicity, elegance, and performance are truly a masterpiece.

Don't get me wrong, I am not asleep at the wheel and always in search of better ideas (e.g., everything that Clive presents).  But every idea I hear I bounce against the beauty of the 4x25 HB PP.  I have found nothing yet that makes me want to tinker with or sway me from the masterpiece.

[Gumby]

Total Real Return of PP vs S&P 500 (Adjusted for Inflation and all Dividends Reinvested)

[MediumTex]

Gumby,

That's a great chart.

I'll take the PP every time.  I think it's a rare investor who can truly hang on through thick and thin with a 100% stock portfolio.

That chart has two periods of over 10 years when stocks had a negative real return.  There is no way I could cope with that psychologically.

[Gumby]

That chart has two periods of over 10 years when stocks had a negative real return.  There is no way I could cope with that psychologically.

I keep thinking that the major reason stocks soared in the 80s and 90s is because of Baby Boomers spending habits. To me the stock boom seems more like an aberration than standard behavior when you look at the big picture and adjust for inflation.

[MediumTex]

That chart has two periods of over 10 years when stocks had a negative real return.  There is no way I could cope with that psychologically.

I keep thinking that the major reason stocks soared in the 80s and 90s is because of Baby Boomers spending habits. To me the stock boom seems more like an aberration than standard behavior when you look at the big picture and adjust for inflation.

If you look at the movement of the 45-54 year old demographic band relative to the rest of the population, it provides a striking correlation to the moves of the stock market.

The fact that this demographic band was in its sweet spot in 1982-2000, PLUS everyone was running up huge amounts of debt makes the remarkable stock market returns less surprising.

Was this period an aberration?  You bet it was.  Do people fully grasp the significance of this?  Not at all.  We are dealing with several cognitive biases here that tend to reinforce a distorted view of reality and perception of the future.  Take a look at the list of cognitive biases at the link below and see how many of them apply to peoples' current perception of what the future is going to look like.

http://en.wikipedia.org/wiki/List_of_cognitive_biases

[craigr]

The period of 1980-2000 was a huge bull market that skews results for stock heavy portfolio strategies and dividends. Dividends have been going down for years and will move depending on tax code changes, etc.

In fact, I remember many years ago that Ralph Nader was in a huff because Microsoft refused to pay dividends and was therefore "cheating" by avoiding all those dividend taxes the govt. was expecting. I just thought that Gates was doing right by his shareholders by limiting unnecessary taxable income and re-investing profits to grow the organization. Why should a company pay out large dividends to satisfy socialists like Ralph Nader at the expense of the company interests?

[LifestyleFreedom]

The period of 1980-2000 was a huge bull market that skews results for stock heavy portfolio strategies and dividends. Dividends have been going down for years and will move depending on tax code changes, etc.

It depends on the underlying companies paying the dividends.  Dividend Aristocrats are companies that have increased their dividends annually for at least a quarter of a century, while Dividend Achievers are companies that have increased their dividends annually for at least a decade.  When the price Mr. Market pays for these companies increases faster than the dividends increase, the yield (i.e., dividend/price) for new purchases goes down.  But the dividends themselves have increased.  Investors who bought their shares long ago will experience an increasing "yield on cost" even though the yield for newer purchases has decreased due to Mr. Market's increasing enthusiasm for these companies over the years.

I use dividend reinvestment programs (DRIPs) for my dividend growth portfolio.  Cash dividends get converted into additional stock with a DRIP.  When I retire and want to live on the dividend stream, I will suspend the DRIPs and just let the cash flow into my account.

The Dividend Aristocrat and Dividend Achiever lists are hard to get on and easy to get off.  There were over 60 U.S.-headquartered companies on the Dividend Aristocrat list before the financial crisis; there are 42 companies on that list for 2011.  The Dividend Achiever list fell from just over 300 U.S.-headquartered companies to just over 200 companies.  GE and PFE are two companies that fell off the Dividend Aristocrat list because of the crisis.  Neither company suspended its dividend, though, and the managements of both companies have indicated a desire to resume increasing the dividend payments again.  It will just take them a quarter of a century to get back on the Dividend Aristocrats list. 

The larger point of the Permanent Portfolio is that an investor's buy, rebalance, and sell decisions are based on what Mr. Market has done with the four asset classes.  The larger point of dividend growth investing, on the other hand, is that the investor's buy and sell decisions are based on what the company itself does; Mr. Market is relevant only at the time of the buy or sell because it's the stream of rising cash dividends paid by the company that are of interest to the investor.  As long as the investor is happy with the dividend stream, the price Mr. Market will pay for the company is immaterial.

The challenge for the investor is to choose companies that will pay a rising stream of dividends over time.  That is not easy to do, but the Dividend Aristocrat and Dividend Achiever lists are good starting points for the analysis (i.e., the race does not always go to the swift nor the battle always go to the strong, but it's certainly the way to bet).

When one owns individual stocks in a Permanent Portfolio (some paying dividends and some not paying dividends), it makes sense to trim the non-payers when rebalancing so long as the dividend payers are still performing.  The dividend payers are adding regularly to either the stock or cash portion of the Permanent Portfolio depending on whether there are DRIPs in place or not.  At least this is how I plan to manage my investments.

My dividend growth portfolio is in a Roth IRA, so how the tax code might change with respect to dividends is not part of the equation.

[craigr]

My dividend growth portfolio is in a Roth IRA, so how the tax code might change with respect to dividends is not part of the equation.

I wasn't clear. The corporate officers, insiders and lead investors often have big blocks of stocks that are not tax sheltered. Dividend policies are going to be dictated by these people first because they are looking to avoid large tax bills. They are not concerned about people holding the stocks in tax-deferred vehicles. Bill Gates for instance would rather not pay dividends over those many years because he held so much stock. It was far cheaper for him to reinvest in the company and take capital gains when needed than collect dividends. In other words, dividend policies can be driven by those with the largest stakes in the company even though the public reasons sound much more mundane.

[smurff]

I keep thinking that the major reason stocks soared in the 80s and 90s is because of Baby Boomers spending habits. To me the stock boom seems more like an aberration than standard behavior when you look at the big picture and adjust for inflation.

Yes, there are aberrations that come into play and shift the S&P 500 in one direction or another.  The sheer number of Baby Boomers and the force of that many people undergoing life changes at the same time has afflicted every institution that generation passes through, and will continue to do so.  But I think that another generation, Generation Y (children and grandchildren of Baby Boomers) or the Millennial generation (these may be the same generation--I haven't been keeping up with names) is actually larger demographically than the Baby Boomers. 

Another reason, Gumby, has to do with the development of the Internet and the web as economic drivers--a development similar in effect to the shift from the Agricultural era to the early Industrial Revolution.  And like the Industrial Revolution, the development of such an economic shift cannot be predicted and tends to develop--or at least show major introduction/change points--every one to five hundred years or so.  (The earlier revolution, from hunter gathering to organized agriculture, began taking place as much as 10,000 years ago, but there were many change points along the way up to and including today.)

In other words, if there had been no Internet or Web phase of the Information Age, that steep slope on your chart for the S&P 500 line from about 1995 to 2000 would be much flatter.  And if there had not been the huge revenues moving around in the late 1990s related to correcting the (unspeakably stigmatized) Y2K issues and the subsequent fall-off in sales after problems were fixed, followed by the pop of the Internet company bubble, the line would have been flatter beginning around 2000 rather than falling off steeply as it did.  Most (I did not verify this, so I could be wrong) of the companies added to the S&P 500 since 1995, like Berkshire Hathaway, do not pay dividends. 

What does this mean?  Even with good trend lines, one can't predict economic events.  At best, one can explain what happened, after the fact, to make the trend line move as it did, and why a company chooses to pay or not pay dividends.  An event may take place--BP's  Gulf of Mexico oil spill last year--that trashes a company's dividend policy.  Keeping a significant portion of one's portfolio invested in non-correlated assets that cover all known "normal" (that is, short of a complete and catastrophic collapse of the economy) investment/economic environments is a wise idea. 

[Gumby]

But I think that another generation, Generation Y (children and grandchildren of Baby Boomers) or the Millennial generation (these may be the same generation--I haven't been keeping up with names) is actually larger demographically than the Baby Boomers.

It's not really the size of the baby boomers that got me thinking about the success of the stock market. It's the fact that Baby Boomers control over 80% of personal financial assets and more than 50% of discretionary spending power. They are responsible for more than half of all consumer spending, buy 77% of all prescription drugs, 61% of OTC medication and 80% of all leisure travel (Source: Baby boomer : Size and economic impact). The birth of the Internet wasn't exactly a happy coincidence. The Internet was spawned from a culmination of the ingenuity, technology, wealth and investments spawned by the Baby Boomers.

To me the entire tidal wave of Baby Boomer wealth and spending that has washed over society over the past 50 years is going to subside over the next few years. And what fills that void?

Baby Boomers hold all of the wealth. Gen-Y has to pay off the accumulated debt.

[MediumTex]

To me the entire tidal wave of Baby Boomer wealth and spending that has washed over society over the past 50 years is going to subside over the next few years. What fills that void?

Nothing fills it.  That's the problem.

Japan went through a similar demographic shift a while back.  You know when they reached their demographic peak?  Around 1990.

[LifestyleFreedom]

Yes, there are aberrations that come into play and shift the S&P 500 in one direction or another.

A good article to read is The Death of Equities that appeared in Business Week's August 13, 1979 issue (http://www.businessweek.com/investor/co ... 263462.htm).  This blast from the past is revealing in terms of what investors were worried about at the time.  Three years later, in 1982, one of the greatest equity bull markets in history started.  So you never know.

BTW, I found The Permanent Portfolio 101 site (http://permanentportfolio.net/) from a link on Wikipedia's Fail-Safe Investing page.  From a link on that newly discovered Permanent Portfolio site, I found the Dividend Investing 101 site (http://learndividends.com/).  I don't know who does these sites, but based on a casual review, they appear to be well done.

[t-bear52]

Thanks Clive. And thanks to every one else who posts. I have lurked quite a while and appreciate this forum and the Booglehead forums on PP.
I have been a died in the wool dividend investor who is still in the accumulation phase. I have been struggling to reconcile PP with this. Clive's post and his postings about dividends in the Variable Portfolio discussion on these forums, gives me the ideas necessary to proceed with PP.
Thanks again to all who post. Learning a lot and look forward to future!! And a special thanks to Craigr and MT
Doug

[MediumTex]

I have been a died in the wool dividend investor who is still in the accumulation phase. I have been struggling to reconcile PP with this. Clive's post and his postings about dividends in the Variable Portfolio discussion on these forums, gives me the ideas necessary to proceed with PP.
Thanks again to all who post. Learning a lot and look forward to future!! And a special thanks to Craigr and MT
Doug

I don't know if this will help you, but the problem with dividend stocks in the PP context is that they are simply not volatile enough.  For PP purposes, you want stocks that are going to give you the full exposure to potential upward moves in the stock market.

I totally understand the allure of nice dividende paying stocks.  I love researching individual stocks and my Mother has some individual stocks in her VP that I have helped her with.  I use sort of a stock barbell approach with dividend paying blue chips on one end and small cap stocks on the other.  Since the March 2009 bottom here is how that has worked out: the dividend payers are up 20-40%, while the small cap stocks are up 150-400%.  If I had only been in the dividend payers, I would have missed out on the gains in the overall market (which have been 100% or so), but by having the small caps as well, I have been able to participate in the rally fully (and even done a little better with the small caps' great performance).

It would take forever to receive enough in dividends to make up for the lagging performance of the dividend payers in the last two years.

The counterintuitive thing about the PP is that while the overall package is very safe, we seek as much risk as possible in each of the threee volatile assets.  This basic fact is something people struggle with a lot and it makes them want to exchange 30 year bonds for VUSTX, gold for TIPS, and a broad market index for solid dividend payers.

As an alternative to the PP, I'll bet there is probably a pretty good investment strategy in something that you might call the "PP Fraidy Cats Strategy", which would consist of 25% 12 month bank CDs, 25% 10 year TIPS, 25% 10 year treasurys, and 25% dividend paying stocks.  Maybe someone could see how this "PPFC" (Permanent Portfolio Fraidy Cats) approach backtests.

[moda0306]

PPFC... I love it.

[t-bear52]

Good Grief. 

[moda0306]

MT,

Your PPFC reminds me of a ridiculous idea I had shortly after the financial crisis: after 2008 I came up with what was to be a new mutual fund  that I was going to call the "G-String Fund."  G for it's components: Gold, Gas, Generators, Guns, Grains (rice & flour).  One would purchase a share of ownership of an amount of these assets which are stored in a secured facility, and would be available for pickup if the SHTF.

Obviously this was done in gest, but made for entertaining conversation.