Tuesday, 28 October 2014

Flying on Autopilot

Just who is flying the plane?
Source
Since the start of September 2014 the DIY Income Investor portfolio has been hammered by the world-wide downturn in financial markets. The corner turned in mid-October, with the portfolio's market value recovering to values seen at the middle of the year: it is currently showing a 7% rise in total value for 2014, a far less stellar performance than in recent years.

Hopefully the markets will recover further over the coming weeks. But I have tried not to get too emotional about it all - mainly by leaving the portfolio on autopilot and removing our greatest obstacle to logical decisions: our emotional reaction.

A 2005 study by three universities in the US found fascinating empirical evidence that showed that emotion is so oriented towards risk aversion that even when the benefits outweigh the losses, our brains err on the side of caution.

The study analysed the investment decisions made by people who were unable to feel emotions due to brain lesions. The subjects' IQs were normal, and the parts of their brains responsible for logic and cognitive reasoning were unaffected. Fear (of loss) seemed to play a large role in risk-avoidance behaviour of the normal participants.

This study is especially relevant because of a concept called the "equity premium puzzle" that has long puzzled financial experts: many individuals prefer to invest in bonds rather than stocks, even though stocks have historically provided a much higher rate of return.

One theory emerging from the study is that successful investors in the stock market might plausibly be called "functional psychopaths." These individuals are either much better at controlling their emotions, or perhaps don't experience emotions with the same intensity as others do. (Warren Buffett comes to mind.)

So, it might be a good idea to be aware of your emotions when investing - and to take steps to counteract your hard-wired risk-avoidance brain circuits. In other words: when the market slumps - stop, and do something else for a while.

The wonderful thing about a portfolio designed for income is that - for the most part - you can just leave it to get on with the process of generating cash. It is a completely different type of investment style compared to that of the short-term speculator, who has to be connected with writhing of the market and who needs to be able sell quickly when things go pear-shaped. By contrast, the DIY Income Investor can shut up the laptop (or switch off the desktop computer) and go for a walk in the autumn sun.

Of course, the success (or not) of the DIY Income Investor approach depends entirely on the selection of securities. If you are not going to sell out quickly at the first sign of trouble, you need to have some confidence that the shares or bonds that you buy are not suddenly going to drop in value. Needless to say, you can't always get it right - and there is always an element of risk. In fact, because I usually invest in high-yield securities (because I want as much income as is reasonable) I do push the 'risk profile' with some of my investments. My experience is that the worst doesn't usually happen - but it does happen sometimes! (Northern Rock, Lloyds, etc.)

So, the basic safeguards are:
  • diversify: do rely on any one security/company for more than around 5-10% of you portfolio and don't rely overly on any particular sector of the market (like banking!)
  • maintain a balance between fixed-income securities (and cash) and dividend shares
  • research any new purchases with a view to medium-term sustainability: look at the business model and the causes for the current high yield (because you are buying high-yield securities, aren't you?).
  • think about wider financial, economic and political trends likely to occur over the medium term and how they might impact your potential purchases

And be ready to leave the portfolio alone for a while and enjoy other things.


I am not a financial adviser and the information provided does not constitute financial advice. You should always do your own research on top of what you learn here to ensure that it's right for your specific circumstances.

2 comments:

  1. Firstly, thanks for the interesting blog I'm always interested in reading other people purchasing decisions.

    With regards running on auto pilot – if your high dividend shares have major corrections does this not always lead to the dividend being cut in real terms (not in % terms) as most firms don’t need to offer 10+% dividends on stock. For example Tesco (which has announced div cut already) – won’t be paying 14.76p per share when the price is at 170 pence.

    How do you manage / approach this given you are after the income?
    Also is there a “easy” technique to spot shares that have high dividends but are definitely due to cut (like Tesco) or is it just down the general research?

    Cheers,
    Keen reader :)

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    Replies
    1. Hi Keen Reader

      Yes, the dreaded 'double whammy' you describe is always possible, because the market is ultimately unpredictable.

      I'm actually a value investor who uses high yield to find opportunities for capital growth; although with the nice addition of dividend/coupon income while I wait for the market to revalue the security.

      As for avoiding these disasters - no, there's no easy solution: so diversify and research. Business mode, level of debt and cash flow are important, as is the management's commitment to paying dividends. The market is telling you something is wrong by creating the high yield. But the market is usually overly scared or risk. If you can use a bit of contrarian thinking, you might be able to discover some hidden value. But always DYOR.

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