The best investors have a plan.

In Lesson 12, we covered the importance of running your investing like a business, and noted that a best business practice is to have a written plan. If you haven’t read that lesson, it would be a good idea to read it before this one.

Why have a plan? When conditions are ambiguous, or your emotions are getting the best of you, you can refer back to your plan. That will help you recall how you viewed investing issues when you were thinking straight.

The purpose of this lesson is to discuss major topics that you should consider covering in your plan. Examples are drawn from:

Give Your Plan a Name

Give your investment plan an inspiring name:

  • Retirement Millionaire
  • Free at Fifty-Five
  • FIRE at 40 (where FIRE = Financial Independence, Retire Early)

The idea is to inspire yourself with a name that suggests a goal that you know is achievable. The planning process leads to a road map that will get you from where you are to where you want to be. The roadmap needs a name.

My wife and I own two dividend growth portfolios. They both have boring names:

  • Dividend Growth Portfolio
  • Perpetual Dividend Portfolio

My portfolios were created many years ago. The names were inspiring to me then, but now they seem boring. If I start another one, it will have a snazzier name.

State Your Goal

Your goal says what you want to accomplish.

Why are you investing? The answer to that question is your goal.

For example, here is the primary goal from my Dividend Growth Portfolio:

Build a reliable, steadily increasing stream of dividends over many years that can eventually be used as income for retirement.

And here is the primary goal from Mike’s Income Builder Portfolio:

Build a reliable, growing income stream by making regular investments in high-quality, dividend-paying companies.

The goals are similar. They differ only in emphasis. My DGP goal states what the income will be used for, while Mike’s IBP goal indicates how he will accomplish his objective.

Both of our portfolios have secondary goals that address total returns.

DGP: Deliver total returns that are competitive with the general stock market as measured by the S&P 500 with dividends reinvested.

IBP: The secondary goal is to build a portfolio that will experience solid total return, something we believe will occur organically because of the excellent companies owned.

In one way or another, most dividend growth investors share the goal of building a large, reliable stream of “passive income” that they can live off of.

In most cases, something along those lines will be your primary (or only) goal.

Don’t set goals that are not realistic and achievable. If you earn $40,000 per year and have nothing saved, don’t set a goal of creating a $70,000-per-year passive income stream in 5 years. Subconsciously, you will know that is impossible, so you probably won’t even bother to get started.

Write Out Your Strategies

Strategies are your plans, policies, and methods for how to achieve your goals.

Your strategies state how you will invest so as to get from where you are now to where you want to be financially when you reach your goals.

I suggest that you keep your strategies pretty general in nature. For example, your business plan shouldn’t name a particular stock to buy. That’s a to-do list item. Rather, your business plan should describe how you will select what stocks to buy.

The following sub-sections cover particular topics that you may want your business plan to cover. Feel free to “steal” any of these ideas for your own business plan. That said, ultimately the business plan is your own, and it needs to align with your personal goals, capabilities, and resources.

  1. Income Goal

You may want to state a specific goal for the income that you want your portfolio to produce. Here is how Mike handles that in the IBP business plan:

Build a portfolio that will produce at least $5,000 in annual dividends within 7 years of the IBP’s inception.

His plan goes on to illustrate how he expects the income to grow year by year. His income goal is realistic, because he is funding the Income Builder Portfolio with $2000 per month to make stock purchases. By the end of 7 years, he will have invested $168,000. His $5000 annual goal amounts to a 3% yield on the total amount invested. That is completely realistic, given typical yields on dividend growth stocks and the fact that they grow their dividends every year.

  1. How the Portfolio Will Be Funded

Having cash to invest means that you must save. It is an unavoidable truth that if you want financial independence in retirement, you will need to save money while you are working.

Obviously, how much you can save is personal to you. But set a goal and then “pay yourself first.” That means to set the savings aside every payday before you blow it on stuff.

Can you save $500 per month? $200? Write that down. Whatever the amount may be, the time to start doing it is now. Because of compounding, the earlier you get started saving, the better.

When you get a raise at work, increase your savings by the same percentage or more.

  1. Stock Selection

My DGP’s business plan includes, by reference, a separate document in which I describe how I select stocks. That document is presented here on Daily Trade Alert as DGI Lesson 19: Grading Dividend Growth Stocks to Find the Best Ones.

That lesson covers such subjects as these:

  • The minimum yield for stocks I buy, which currently stands at 2.0%. (Earlier in the DGP’s life, I required 2.8% minimum yield.)
  • The minimum dividend growth rate (DGR) that I require, which is 2% per year. In practice, I seek higher DGRs unless the stock has a very high yield (say >4-5%).
  • Dividend safety.
  • Company quality, including the use of quality and credit ratings from companies such as Morningstar, CFRA, and S&P.
  • Company financials, including earnings, cashflow, and debt.

In a similar vein, Mike’s IBP business plan states this about stock selection:

Assess each company’s business model; dividend growth history; “moat” (competitive economic advantage); financial strength (through metrics such as earnings, revenue and free cash flow); and other readily available data.

A good place to start your stock hunt is the Dividend Champions, Contenders, and Challengers list. It shows every stock that has been raising its dividend continuously for 5 years or more. For many investors, appearance on that list is the minimum qualification to call something a “dividend growth stock.”

  1.     Valuation

Under valuation concepts, paying too much for even a great company is not a promising way to invest.

As Warren Buffett has put it:

Our…approach [to investing] can be continued soundly only as long as portions of attractive businesses can be acquired at attractive prices…. For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments. [1982 Berkshire Hathaway Letter to Stockholders]

As discussed in DGI Lesson 11 on valuation, I want to buy companies when they are fairly priced, or better still when they are on sale.

For my own investing, I only buy stocks at Fair valuations or better. This is a hard and fast rule for me. If I am tempted to stray – the temptation to buy an excellent company at a too-high price can be strong – I look back at my investing plan to remind myself of what I am doing.

  1. Dividend reinvestment

In DGI Lesson 10, we reviewed the two ways to reinvest dividends: By dripping them back into the companies that distribute them, or by accumulating them and then making targeted purchases.

As it happens, the two portfolios I am using as examples in this article – the Dividend Growth Portfolio and the Income Builder Portfolio – employ these two approaches. I accumulate dividends and reinvest them in chunks, while Mike Nadel drips them.

Over the years, you will reinvest lots of dividends. The total you reinvest may well exceed the amount of “new cash” that you use to establish your portfolio in the first place. In a little over 10 years, I have reinvested almost $27,000 in the DGP compared to $46,783 that was in the portfolio when I started it. In a few years, the dividends collected and reinvested will be more in total than the amount I started with.

Just because the dividends arrive in small amounts should not lead you to be careless with how you reinvest them.

Give the subject some thought and choose whatever’s right for you. Many investors do both: Drip some stocks but accumulate the dividends from others. It’s totally up to you.

Of course, once you retire, you will probably stop reinvesting, or you will only reinvest part of what you receive and spend the rest. That will be because Financial Independence has arrived: You can live off your dividends and not have to work at a job any more unless you want to!

  1. Number of stocks and diversification

Different investors have portfolios of different sizes, and they take various approaches to diversification.  Your business plan should address what you want your portfolio to look like as it gets established.

How many stocks to own is a function of factors like these:

  • how many companies you can keep track of;
  • how much income you want to have at risk from any one company;
  • whether you want a “core and satellite” type of portfolio;
  • to what degree you want to diversify across economic sectors; and so on.

Here is how I state my policy in the DGP:

  1. The portfolio will normally contain 20-30 stocks.

  2. The portfolio will be well-rounded. It is diversified across economic sectors and industries. It is also diversified across a variety of yields and dividend growth rates.

  3. The portfolio is meant to be a straightforward illustration of all-purpose dividend growth investing. It will not be unduly tilted either toward fast dividend growth or high yield stocks. The DGP’s yield will usually be in the vicinity of 3.5%. Its annual dividend growth rate is expected to be in the 6-8% range per year.

  4. The portfolio will normally hold no more than 10% of its total value in a single stock.

My target of 20-30 companies would be too concentrated for some investors. I know many dividend growth investors who want at least 50, or even 100, companies in their portfolio. They see the higher number as a risk-control tool, spreading out their bets.

The math is easy: If you own 50 companies in equal amounts, only 2% of your portfolio is at risk from any one of them. If the number of companies drops to 33, the amount at risk rises to 3% for each one.

But this is not completely a math question. How many companies to own is a personal question. Base your answer on your own comfort level with a larger or smaller number of companies.

When you are first starting out, you’ll own a small number of companies by necessity. Use your business plan to describe the building process as well as what your portfolio will look like after you have built it out.

  1. Rebalancing policy

Connected to the question of how many stocks to own is how much weight each carries in your portfolio.

Position sizes can wander over time as the result of price changes in the market. Also, if you drip dividends, some positions will grow faster than others, because they will be receiving more dividend reinvestments.

Some investors want an equal-weighted portfolio. Therefore they rebalance regularly.

Other investors don’t care as much about having equal weights, preferring instead to have more money in certain companies that they call “core” positions.

I have seen research supporting frequent rebalancing, occasional rebalancing, and no rebalancing. It’s up to you.

Say you own 20 stocks, and your target is to own them about equally, meaning that each position represents 5% of your portfolio. There are several ways to look at a rebalancing policy:

  • You could rebalance by the calendar, say every 6 months or 12 months. If you do this, be aware that you will incur trading costs to make small adjustments, so you probably want to build some leeway into the equal-weight goal.
  • You could rebalance only when positions get way out of whack. For example, you could accept any position that falls within a 4-6% range, and reweight only when a position gets outside that range.

Of course, you can reject rebalancing except if a position grows beyond a specified maximum size. That’s what I do in the DGP:

The portfolio is not rebalanced on any set schedule. However, occasionally a large position may be trimmed, with the money used to purchase or build up other positions

  1. Selling policies

Most investors find it harder to decide when to sell than what and when to buy.

The urge to sell is often emotional, especially when the market is falling. Human nature induces many investors to flee to cash, but that is often a self-defeating action. Investors, on average, sell too soon and then buy too late, missing the run-ups when the period of falling prices comes to an end.

Risk tolerance is all about psychology. In investing, you are not running from a sabre-tooth tiger. Fight-or-flight responses generally do not help you toward long-term success. You are dealing with the market. Do it rationally.

Here are my selling policies:

  1. This portfolio is expected to have a low turnover rate. Unless there is a strong reason to sell or trim a position, the default action is to hold. The underlying strategy is to buy, collect, and hold good dividend growth stocks for long periods of time.

  2. However, selling or trimming will be seriously considered if any company/stock:

(a) Cuts, freezes, or suspends its dividend.
(b) Bubbles or becomes seriously overvalued.
(c) Is impacted by significant fundamental changes.
(d) Is going to be acquired.
(e) Announces plans to split itself into 2 companies or spin off a significant portion of its operations.
(f) Sees its current yield rise above 9% or drop below 2.0%.
(g) Grows to where it is beyond 10% of the portfolio.

Those are my selling guidelines. They are not hard-and-fast rules. The language “seriously consider selling” is carefully chosen. Even if a stock freezes its dividend, I want the flexibility not to sell it. Maybe the company has a good reason, and it is clear that dividend increases will resume shortly.

Guidelines (2)(b), (f), and (g) interact. If a stock’s market price shoots way up, its valuation may deteriorate. Since yield = dividend / price, its yield may fall way down. And the price increase may cause its weight in the portfolio to go beyond my 10% maximum.

Key Takeaways from this Lesson

1. If you intend to run your investing like a business, a best practice is to have a written business plan.

2. Your plan should spell out your investment goals and strategies. It’s a roadmap for success.

3. Topics to cover include:

      • Your income target
      • Saving for retirement
      • How to select stocks
      • Dividend reinvestment
      • Number of stocks and diversification
      • Selling guidelines

4. Consult your business plan when you’re in a confusing situation or you feel that you are straying from the path you chose. Its purpose is to guide you without being a straightjacket.

Dave Van Knapp

Click here for Lesson 14: Grading Dividend Growth Stocks to Find the Best Ones for Your Portfolio 

This lesson was updated 9/16/2018

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