Cognitive Biases during Investing

Things have really been getting a lot busy with work and life lately. It is summer time here in the US, and from what I can tell, the general public is out and about, trying to spend a lot of time outdoors. I can see the pandemic restrictions being lifted as well and it seems like things are slowly returning back to some semblance of normalcy. The markets are rallying along as well, and even all this talk of inflation has not really slowed it down. Does this mean that Mr. Market is treating this rise of inflation as a transitory event? Time will tell.

Even with all this news, I am continuing to stick to my strategy. While I tend to my responsibilities of my day job and my family’s needs, my capital deployed in high-quality businesses earns passive income for me in the form of dividends.

In my spare time, I have been binge-reading articles/watching videos on valuation, with an overall goal of adding more tools to my repertoire to analyze businesses effectively. One such person who has been widely quoted on the subject of valuation is Prof. Aswath Damodaran from the NYU Stern School of Business. If you have not checked his website, I humbly urge you to do so, as I think it is a treasure-chest of useful information/tools on the subject of valuation.

One of the topics that I happened to read about is how biases can impact valuations and this subject perked my interest. Here is what Prof. Aswath writes on this subject:

“When you start on the valuation of a company, you almost never start with a blank slate. Instead, your valuation is shaped by your prior views of the company in question. The more you know about a company, the more likely it is that you will be biased, when valuing the company…In principle, you should do your valuation first before you decide how much to pay for an asset. In practice, people often decide what to pay and do the valuation afterwards.“

Cognitive biases, in general, impact our ability to think and reason logically. Investing is no different. It is important to understand them and ensure that you are avoid them when evaluating businesses. Here are some well known biases that can impact your investment decisions.

Anchoring Bias

We humans tend to rely a lot on the very first piece of information that we receive and use that as an anchor or an initial reference point. As we receive new information, it is processed with reference to this anchor.

Anchoring is used very effectively by folks in the sales and marketing domain. One example that readily comes to mind: if you are ever at a car dealership shopping for a new car, notice how the car dealer will first show you the expensive models before showing you a “cheaper” model, thereby prompting you to buy the latter.

Here is another classic example, this time it is Steve Jobs using anchoring during an iPad promo event.

Anchoring, by itself, may not be such a bad thing in investing, if you are anchoring your brain to the intrinsic value of the investment. However, if your brain fixates on the wrong data point, such as say stock price alone, it can have a damaging effect on your decision making.

Confirmation Bias

Simply put, confirmation bias is a tendency to only search for, favor or interpret proofs that align with our existing point of view. In fact, taken to its extreme, this can result in misinterpreting contradictory evidences to support the current view.

This can be particularly harmful when objectively analyzing a business. If you are approaching the analysis with a “loaded mind” where you already think that “This is a great business“, you will tend to interpret data put in front of you through this prism and simply dismiss other non-conforming data as outliers.

Outcome Bias

This is a tendency to base the effectiveness of a decision through its eventual outcome, and neglecting all the other factors that may have contributed to the outcome. I view this bias through two hypothetical examples:

I bought a stock, and the stock price went higher the next day. Therefore, my decision to buy was correct.

OR

I sold a stock, and the stock price dropped the next day. Therefore, I am right about selling this stock.

Conventional wisdom states that the stock price is probably the worst place to look at when it comes to validation for your decision to buy/sell a stock.

Bandwagon Effect or Herd Mentality

This is a tendency of adopting a specific style or belief simply because others are doing it. In investing, this might be summarized as:

Everyone is buying this stock, therefore it must be a good business.

There is also the common case of FOMO aka Fear Of Missing Out, because you are always wondering about what the other investors know about this business that you don’t.

There are several examples from history to show how this generally does not end well for the investor. One such funny example is quoted by Benjamin Graham, the Godfather of Value Investing, in his famous book titled The Intelligent Investor:

And back in the spring of 1720, Sir Isaac Newton owned shares in the South Sea Company, the hottest stock in England. Sensing that the market was getting out of hand, the great physicist muttered that he “could calculate the motions of the heavenly bodies, but not the madness of the people.” Newton dumped his South Sea shares, pocketing a 100% profit totaling £7,000. But just months later, swept up in the wild enthusiasm of the market, Newton jumped back in at a much higher price—and lost £20,000 (or more than $3 million in today’s money). For the rest of his life, he forbade anyone to speak the words “South Sea” in his presence.

Availability Heuristic Bias

This is a tendency to place undue importance on events and examples that come readily to mind. This is easily seen in a lot of commentary and analysis on investing. Investors tend to remember the dot-com boom or the Great Financial Crisis in vivid detail and sometimes use that a basis for future investments.

So what does all this mean?

Through this discussion, we can derive the following conclusions:

1. Your greatest enemy and your greatest friend in all your decisions, investing or otherwise, is your very own sub-conscious.
2. If you already own a particular stock and think the underlying business fundamentals are sound, one technique that I have found useful while analyzing such a holding is playing the Devil’s advocate i.e. now look for reasons why you would want to sell this stock and be as objective as you possibly can.
3. Valuation is not an exact science, quite far from it actually. In fact, as a result of these biases and assumptions, there is a good chance that your estimations are completely wrong. It is for this reason that diversification in your portfolio helps to safe-guard against such bets going wrong.
4. When in doubt, use the philosophy based on Occam’s Razor i.e. the simplest explanation/model is usually the best way to attack an estimation problem. The more complicated your model gets (including more inputs and assumptions), the greater the risk of your biases sneaking in.
5. Always invest with a Margin of Safety, because at the end of the day, all valuations are estimates and they could be wrong.

That’s it, folks! I hope you found this article useful to read. Please drop a comment below to share your thoughts on this subject.

Until next time…

Advertisement

Monthly Income Update – May 2021

This is the first of what should hopefully be a long and never-ending series of monthly update posts. Through this series, I will be sharing the dividend income received during the month as well as any buys/sells made during the month.

Let me first start by stating that this is perhaps my most favorite part of dividend investing : receiving cash for simply investing in high-quality companies and not even having to lift a finger for it. If this amount was instead sitting in a bank account, I would have earned nothing for it. Instead, I am putting my money to work for me. The dividends received are invested back into the portfolio along with some additional capital to create a snowball. With every step, I am that much more closer to financial independence!

Dividend Income Received

During the month of May 2021, I received dividend income from the following companies:

Company (Ticker)	Amount
Apple (AAPL)	$0.85
Abbvie (ABBV)	$9.32
Albertsons Companies (ACI)	$0.53
Caterpillar (CAT)	$0.88
Clorox (CLX)	$5.31
Costco (COST)	$2.28
Procter & Gamble (PG)	$4.97
AT&T (T)	$2.23
Texas Instruments (TXN)	$3.06
Verizon (VZ)	$2.95
Realty Income (O)	$2.85
STAG Industrial (STAG)	$0.73
Total	$35.96

Buys/sells during this period

I made the following stock purchases during the month of May 2021:

“Staying in the game” purchases: AAPL, JPM

Other purchases: MMM, AFL, ACI, O, STAG, CTRE

The “staying in the game” purchases are simply dollar-cost averaging into the stocks since the threshold for number of days since the last purchase made had expired (threshold configurable based on category of the holding in my spreadsheet setup). The tranche size is dependent on the current valuation of the stock in question (i.e. smaller tranche size for an overvalued stock).

I have no sells during this month.

Disclosure: Long all the stocks mentioned in this post.

Dividend Increases – June 2021

Perhaps the most exciting thing about dividend growth investing is receiving news about companies hiking their dividends. This is akin to receiving a pay hike, and lets face it, everybody in the world enjoys that!

The following companies in my portfolio hiked their dividends:

Clorox (Ticker: CLX)

The Clorox Company hiked its dividend by 4.5%, now paying a quarterly dividend of $1.16/share. This marks the 45th year of dividend increases for this Dividend Aristocrat. Over the last five years, this company has managed to grow its dividends at a 5-year CAGR of around 7.59%. The stock is currently trading at a FWD dividend yield of 2.66%. While the increase this time was lower than the 5-year CAGR, I am still bullish as far as long term prospects. Hence, this is one of my core stocks in my dividend portfolio.

UnitedHealth Group (Ticker: UNH)

UnitedHealth Group increased its dividend by 16% to now pay a quarterly dividend of $1.45/share. UNH has been growing its dividends pretty aggressively since the last 5 years, with a CAGR of almost 20%. Hence, this is a growth-like holding in my portfolio. It is generally accepted that healthcare system in the US is “broken”. While that is not so ideal as a consumer, this makes a great investment opportunity.

Caterpillar (Ticker: CAT)

Caterpillar hiked their quarterly dividend by 7.7% at $1.11/share. CAT is on the S&P 500 Dividend Aristocrat index and has been rewarding shareholders with increased dividends for the last 27 years. CAT finds a place in the growth-like category of my portfolio, but I am fully aware about its cyclicality and how the recent climb in stock price might be just a part of that trend.

Target (Ticker: TGT)

The biggest surprise in this list as far as dividend increases came from yet another Dividend Aristocrat. Target hiked its quarterly dividend by a whopping 32.3% at $0.90/share. This represents the 54th consecutive year of dividend increase for this company. The reason for the surprise was that Target has a rather low 5-year CAGR of 3.9% (actually their 3-year CAGR is 3.1 %). While I was expecting a larger increase especially after their stellar earnings beat during the last quarter, I was certainly not expecting such a large increase. Just goes to show that if you hold quality companies where the management’s interests align with that of the long-term shareholder, these companies will eventually reward you handsomely.

T. Rowe Price Group (Ticker: TROW)

TROW, yet another dividend aristocrat, made my day when they declared a special $3.00/share dividend. This after having hiked their quarterly dividend by ~20% earlier this year. Simply speechless! 🙂

I sincerely thank the hard-working employees at all these companies!

Disclosure: Long CLX, UNH, CAT, TGT, TROW.

My Dividend Portfolio Allocation Strategy

I view dividend stock investing as something similar to growing a tree: you initially plant a seedling and do your part by providing it with a lot of care and nourishment. With time and patience, this little seedling will grow into a enormous tree that will eventually pay you back by providing fruits, flowers and also shade. Similarly, with dividend stocks, you simply need to invest in high-quality companies consistently and patiently and with time, through reinvested dividends and also dividend growth, the resulting compounding will blossom into a cash-generating machine that will serve you well for decades to follow.

In one of my earlier posts, I briefly touched upon entry criteria for selecting such companies. But how does one construct a dividend portfolio of such companies? That is the subject that I shall delve into in this post.

Before getting started though, I would like to state a few important background notes regarding my personal situation:

• My dividend portfolio only represents a certain percentage of my overall investment portfolio (which also includes things such as my retirement accounts like 401(k), Roth IRAs and a HSA).
• My general strategy is to max out contributions to my retirement accounts. Following that, I will use any remaining funds to invest in my dividend portfolio.
• I follow a process of hybrid investing: wherein I stick to a mix of investing in low-cost index funds, low-cost ETFs in my retirement accounts and invest in individual dividend paying stocks in my taxable account.
• I also have a very small percentage of my overall portfolio allocated to growth stocks.
• For the purposes of reducing my overall taxes, I invest in REITs in only the tax-advantaged accounts (currently Roth IRA and HSA).

With all that out of the way, let me get into the crux of my allocation strategy for my dividend portfolio.

The general idea behind my allocation strategy is two-fold:

1. Have enough upside such that when the broader market gains, my portfolio not just gains but beats the overall market.
2. Have enough risk-tolerance such that when the broader market dips, my portfolio does not dip as much.

I attempt to achieve this through categorization based on certain aspects.

Categorization based on My Investment thesis

My general rule of thumb is that for every stock I own, I will have a brief one-pager document explaining the reason why I hold the stock and the associated risks. I refer to this as my investment thesis for the stock. With this in mind, I have categorized my allocation into four broad buckets:

1. Core stocks: These are my sleep well at night stocks and represent the foundation of my portfolio. These are the classic blue-chip companies that have been around for decades and withstood several economic downturns and come out on top. These holdings offer a decent starting dividend yield but are not going to grow rapidly for the coming decades. However, they are still in the process of innovation and I am very confident that they will remain relevant during my lifetime.
2. Growth-like stocks: These stocks are in a phase of aggressive growth at this stage. They are relatively younger in their dividend history in comparison to the Core stocks. Their starting yields might be much lower but they have substantially higher dividend growth rates and a lot of runway (in terms of dividend payout ratio) to increase their dividends.
3. Bond-like stocks: I do not own bonds in this portfolio, but when it comes to de-risking my portfolio, I rely on these type of stocks. Some of these offer a relatively high-starting yield but they are very slow growers.
4. Speculative stocks: These are the stocks that I have the least confidence in. This is either because of the nature of the sector they are in or because of mixed signals from the management about the commitment to long-term shareholders. I would generally have this as the smallest allocation in my portfolio.

In my view, this categorization provides long-term stability and future growth while also safeguarding against risk during an economic downturn. Each stock has a specific role to play and in conjunction with the other stocks in the portfolio, they form a team to play offense/defense whenever necessary.

Nothing about this categorization is set in stone as such and I may choose to move stocks from one category to another depending on changing trends. In general though, I will skew towards keeping the allocations for the first two buckets (Core and Growth-like) a lot more higher than the last two categories.

Categorization based on Sector

I have split up my allocation across different sectors in the following manner.

The allocation is a reflection of my investment style : very conservative/defensive with a low risk tolerance. I have the highest allocation towards the Consumer Staples & Retail sectors followed by Healthcare. This is mostly with the understanding that regardless of what happen in the stock market, the average consumer is still going to shop daily for consumer products that he/she will use on a day-to-day basis.

Likewise, the healthcare sector is always going to be forced to innovate to remain competitive. A crazy year when the world was grappling with the COVID-19 pandemic has been a testament to that theory. Furthermore, my wife is an engineer with a background in biotechnology, thus bringing this sector in her circle of competence. I have a sizeable allocation the Tech sector since I work as an engineer in the semiconductor industry and understand its intricacies fairly well. This follows my advice from one of my previous posts about investing in what you know.

The least allocation is towards the Energy sector which is mostly composed of Big Oil. While I think the oil industry is going to remain relevant for the remainder of my lifetime, I am also cognizant that there will be a greater push towards use of cleaner sources of energy for large scale infrastructure projects.

As stated before, I do not own REITs in this portfolio to save on taxes (since distributions from REITs are taxed as ordinary income per IRS regulations here in the US). Instead, I own REITs in my tax-advantaged retirement accounts. I will cover my REIT allocations in a future post.

Capital Allocation Strategy

My primary focus is to max out contributions to my retirement accounts for the calendar year. Once I have achieved this, I allocate a fixed amount for contribution towards my dividend portfolio each month. The broker I use (M1 Finance) does not have a traditional DRIP feature, where dividends can be reinvested back into the same stock. Instead, it provides an “auto-deposit” feature which can be used to purchase stocks automatically: generally M1’s algorithm attempts to buy stocks that are currently underweight in your portfolio based on your target allocation. I have mostly not used this feature since I want to be in complete control of what buy orders I am placing rather than rely on any algorithm.

I pool all the dividends that I have received along with any remaining capital and buy stocks that I think are the best value at any given moment. Also, to remove any emotion out of the picture and to ensure that I am consistently dollar-cost averaging into all my holdings, I have a spreadsheet setup that tells me the number of days (configurable for each category of holding) that have elapsed since my last purchase on any given stock. I call these as “staying in the game” purchases, as these purchases are typically for a small dollar amount where the valuation of the stock is not as important.

Dividend Portfolio Revealed

At the time of writing this post, my dividend portfolio contains the following holdings.

Here is an alternative view of the portfolio in a treemap format.

At the time of writing this post, there are reports that AT&T will be cutting their dividend following a spin-off of WarnerMedia and merging it with Discovery. I am planning to continue holding my AT&T shares for now but this reinforces my original thesis of why I put this holding in the “speculative” bucket. Thankfully, I have enough safeguards in my portfolio due to diversification to protect myself against this news.

I am fairly happy with the number of holdings I have in my portfolio (31 at present). Generally, I am not as much focused on this number itself. But I would like to keep this to a manageable number since it would be very difficult to track several companies and periodically research them.

In some future posts, I will dive into the reasons why I hold each of the above stocks.

Summary

So there you go! That is my portfolio allocation strategy and my portfolio. I would love to hear your thoughts on this subject. How have you constructed your portfolio? Do you diversify across sectors like I do? Please let me know in your comments below.

Happy Investing!

Articles of Interest – June 2021

Call me old-school, but I enjoy reading blog subscriptions on my old RSS feed reader. There is a wealth of information out there in the blogging community regarding investing in general, and specifically dividend stock investing.

A fellow dividend investor + blogger, Engineering Dividends, has a practice of sharing an article of interest and he/she has this setup as a post-series. I drew inspiration from this and decided to do the same on my own blog.

So here are some articles that I particularly enjoyed reading from the last few days:

• How Ronald Read managed to accumulate a dividend portfolio worth $8 million : Dividend Growth Investor (DGI)

DGI is one of the first bloggers that I started reading when learning about dividend growth investing. I have learned a lot from his articles and continue to do so. This post talks about Ronald Read, an average citizen who worked as a janitor and/or at the gas station, invested in high-quality dividend paying stocks throughout his life. By the time of his death, he had amassed a portfolio worth $8 million. I find this story inspiring and it re-affirms my belief in this strategy. My biggest takeaway from this is that you do not need to be a wall-street big-shot to be a successful investor. Even average retail investors such as you or me can be successful using such a simple investing strategy.

• How I built my dividend portfolio : My Own Advisor

I started following this blog fairly recently and the above post happened to be one of the first ones that I read. I find the post to be a good starting point for anyone thinking about getting started with dividend growth investing. Mark has done a pretty good job of covering a lot of breadth without overwhelming the first time reader. I also find a lot of synergies between my approach to investing and the approach that Mark has described in this post.

• The unexpected news… death of a coworker : Tawcan

The last article of interest is a rather somber one, but an important one nonetheless. Tawcan, one of my favorite bloggers in the dividend investing community, writes about how the news of a death a coworker helped put things in perspective with regards to his overall pursuit of financial independence.

In my previous post, I talked about the importance of making sound financial decisions and hinted at cutting down unnecessary expenses whenever possible. While this is a reasonable suggestion, there is a fine line here. And I realize that this pursuit can be taken to an extreme. At the end of the day, we all live once and life is short. And there are times when living the moment with your family and/or loved ones is more important than anything else, even if this means spending some money in that process. Money spent on a vacation with your family or on a wedding, might seem extravagant and unnecessary momentarily. But in the grand scheme of things, those memories that are priceless, which no amount of money can buy back.

So, it is important to strike a balance. Weigh the pros and cons of each major financial decision you make. Ensure that you are living the moment and spending a happy life one or the other. But don’t lose sight of securing your future as well. It is your hard-earned money, spend it wisely. 🙂

Making sound financial decisions

Over the course of investing in high-quality dividend stocks, I have realized that this strategy relies on two key facets:

• Time
• Capital Invested.

Let me elaborate on how each of these impact your portfolio’s performance.

Time

In general, the longer you stay invested in the stock market, the greater the odds of you generating a better return on your original invested capital. Hence, it is generally better if you start investing early in your lifetime and stay invested throughout.

Capital Invested

The other factor is simply how much amount your can contribute towards your investments and at what frequency. This is largely dependent on your personal lifestyle and the financial choices you make throughout the course of your lifetime.

I wanted to touch on this second aspect since it is often overlooked when it comes to investing.

A simple equation to look at your savings is as follows:

Savings = Income Generated – Expenses

Common sources of generating income are your regular day job and any side-hustles. One approach to maximize your savings is to excel regularly at your day-job, invest in yourself through improving your existing skillset such that you can command a higher salary. You can further supplement this by having one or more side hustles. But pretty soon, you will come to a point where you will simply be unable to maximize your income: either because of factors that are simply not in your control (eg. your employer cannot afford to pay you more), or because you simply do not have the time or the bandwidth to pick up more side-hustles.

This brings to the other piece of the equation: expenses. Compared to your income, on the face of it, this seems to be a little more under your control. Sure there are aspects such as groceries, gas or daily-use items that we cannot avoid paying. Because we all got to eat, take a shower, commute to work etc. 🙂 I get that.

But what about that fancy new car you are planning to buy (or just recently bought)? What about that fancy new smartphone you are planning to buy during Christmas this year? What about those frequent takeout meals you like spending on? These are lifestyle choices and they eat into your savings, thereby reducing the available capital that you could have otherwise deployed towards generating more wealth.

Even before you begin investing a single dime in the stock market, it is critical that you self-introspect and take note of your current financial situation. Monitor all of your expenses for any given month (or months), sit down with your family or loved ones who live with you and seek guidance on which expenses can be cut down. Work towards creating a reasonable monthly budget and stick to it.

Among the daily expenses that are common in each household, the ones related to paying off debt will impact your journey to financial independence the most. In this specific regard, I highly encourage the interested reader to look at Dave Ramsay’s baby steps. The first four steps, in particular, are critical. While I do not agree with Dave Ramsay’s thoughts on investing, I also cannot agree with him more about paying off debt sooner.

If you are currently in debt, please know that this is not the end of the world. We have all been there (including yours truly 🙂 ). It is actually pretty easy to turn this around and knock off this debt. You just need to turn that “Beast Mode” setting ON and aggressively eliminate this debt. If I have managed to open your eyes and forced you to think about this seriously, I have achieved my goal.

If you are not having any outstanding debt (other than your mortgage), pat yourself on the back! From this point on, you should first look at having an emergency fund. I typically recommend keeping a stash of cash to cover for expenses for atleast 3-6 months. What this amount would be is subjective to each family’s individual lifestyle.

You should then look at maxing out your retirement accounts such as 401(k) and IRAs. Note that these retirement accounts are applicable to US residents only. Your country’s tax laws might call them something else and treat them accordingly for tax purposes. Please check with your tax advisor.

If you have maxed out your retirement accounts, you are killing it! Congrats!! Now, it is really a question of how to choose to invest the remaining money into income generating assets. There are several options available to you depending on your preferences and risk tolerance. My personal preference is to use part of my capital and invest in high-quality businesses that will pay me back cash in the form of dividends. Your strategy might be something else. There is no one right/wrong answer here. It depends. The key here is you are making financially sound decisions to invest in yourself and securing your future.

I would love to hear your views on this subject. Please let me know by dropping a comment below.

Photo courtesy: Damir Spanic

Disclaimer: Please read my disclaimer here.

Picking good dividend stocks : Fundamentals

Individual stock picking is hard. There are just so many options. Not only is it overwhelming, it is very easy to get it completely wrong. How do you know if a stock pick is really good? What qualifies as “good” in the first place?

Let us first focus on basics.

Peter Lynch, a former manager of the Magellan Funds at Fidelity Investments, is known as one of the most successful investors in the world. I have learned a lot from his writings and talks, mostly because I can relate to how he can simplify investing for average joes such as myself.

Perhaps the best advice I received through Peter Lynch is the quote I have referenced in the picture above. Let me elaborate on that a little more.

Do this exercise for me: Dissect your daily routine by thinking about the stores you shop at, the restaurants you dine at. Look around your office or your home and monitor the products you use on a daily basis. Some of these products are from businesses that you have already heard of. For instance, that post-it note that you are using at office is from 3M (ticker: MMM), a famous company that is known for several such products that you might be using around your office and/or home. That iPhone you are using, is from Apple (ticker: AAPL), another famous company. That Tylenol tablet that you consume when you are not feeling well is from another famous company called Johnson and Johnson (ticker: JNJ).

You get the idea. As a consumer, you already know of several such companies simply because you are buying/using their products. As it turns out, ALL of the above companies also happen to pay cash back to their shareholders, just as a thank you for investing in their business. How cool is that!

So does this mean you should blindly invest in every such company that you can find around you. Certainly not! But you have a better chance of success when investing in a business that you can understand or already know about rather than investing in a business that you have never heard before in your life.

With all that said, in addition to knowing a little bit about the business, I also use the following basic rules to screen such stocks:

1. Companies with a good starting dividend yield: Typically, I don’t have a cut-off as such here. But an unusually high yield number might be a red flag and point to something wrong with the business.
2. Companies with a reliable history of growing dividends: I normally look for a history of atleast 5 years.
3. Companies that have a steady dividend growth rate: I look for Compounded-Annual Growth Rate (CAGR) of atleast 5%.
4. Companies where the dividends are relatively safe: usually determined by looking at the dividend payout ratio. I look at companies where the payout ratio of less than 65% (Note: The only exception to this rule is when I am considering investing in Real-Estate Investment Trusts or REITs. More on this in a future post).

Note: I highly recommend reading this page on Investopedia to familiarize yourself with the some of the above terms.

This just serves as a starting point. Once I have a filtered down list of stocks that I could potentially own, I begin researching the companies further to see if they are a good fit to my overall investing strategy.

Disclosure: Long MMM, AAPL, JNJ