How to define risk in dividend paying stocks?

For many equity investors these days, risk is usually defined as an unfavorable fluctuation in stock prices. This means that an investor who purchased Coca-Cola (KO) at $40/share, and observes the price decline to $30/share, had a $10 unfavorable move in the price against them. This view on risk could be adequate for investors whose investing timeframe is in days or months. The problem with defining risk with stock market volatility however, does not make much sense for long-term investors.

As a long-term investor, I focus on identifying companies with strong fundamentals, and good business prospects, which I then try to accumulate at attractive valuations. I then monitor long-term business trends, read annual reports, and check to see if the company is earning more and paying out more in dividends. As a result, the data points I use are in “years”, rather than days or months. If you expect to hold a company for 20 years, focusing on a decrease from $40 to $30 is relatively immaterial. In my investing, I usually avoid focusing on price fluctuations, except as a tool to uncover cheap stocks to buy. Of course, if this drop is because of some material information that could affect the long-term prospects of the business, you need to evaluate whether you want to add or liquidate your position. However, if this drop is because stock prices are simply going down in tandem, chances are that you are not getting much from this information.

For me, risk is defined as a situation where I lose my all of investment capital. When I lose my investment capital, I would be unable to make more investments and earn more money from it. This permanent loss of capital is usually associated with situations such as business failure from the company I invested in. This would mean that not only would I lose out on a portion of my dividend income, but would also be unable to replace it because the capital base has dwindled significantly. This is why it is important to diversify my investments, in order to reduce the impact on my capital base from the effects of one company failing. If the stock I own merely goes from $40 to $30, but the fundamentals are unchanged I would not see that as a risk, but rather as the cost of doing business. Therefore, deteriorating fundamentals are a much larger risk to your capital and dividends than stock price fluctuations alone.

I believe that prices are what you pay, but value is what you get. Over the next 20 - 30 years that you hold dividend paying stocks, you will likely suffer big declines in stock prices on several occasions. This could be due to a lot of factors like recessions, wars, oil shocks, as well as a lot of company specific factors. The goal is to start with the facts first, such as a news release or an annual report for example, rather than focus on prices alone, and avoid making decision on rumors and opinions which are not grounded by facts. It is also important to be mentally prepared for declines in prices, and not panic and do something stupid like selling everything.

I would consider selling only after a dividend cut, in order to avoid acting on noise. The reason behind this rule is two-fold. The first reason is that companies do not grow to the sky in a straight-line. There are roadblocks along the way. At the time these roadblocks occur, it is very difficult to evaluate if they will result in a permanent loss or not. When Johnson & Johnson (JNJ) had issues in one of its subsidiaries in 2010, many investors feared the worst. Since then however, the company has managed to clean up operations, and succeeded. If you had sold back then, you would have missed out on the opportunity. As a result, any negative news might be scary at the time, but in the grand scheme of things, could be simply considered noise. This is why I note these negative events, but might refrain from selling off my position. I have also sold when I found valuation to be too high, but I have had mixed results from this scenario.

Second, in my analysis of companies, I have noted that when a company cuts dividends after it has paid and increased them for decades, it is usually admitting trouble. However, there is more trouble ahead, because boards typically make their decisions on whether to increase or cut distributions based on the business prospects for the next 2 – 3 years. In the Johnson & Johnson case above, the company was experiencing some issues, however they kept raising the dividend and kept earning more per share. This indicated that the problems are not as huge as expected.

Of course, selling after a dividend cut is not effective 100% of the time. However, it is a fail-safe mechanism, that can allow an investor to have a reasonable confidence that selling at this event will leave them with some capital. This capital can then be deployed in other attractive opportunities that will generate rising streams of income. In addition, selling after a cut removes any guesswork of whether the negative events you are learning about the company are noise or not. It should also be a wake-up call for the investor who “falls in love” with a company, and could expect to rationalize themselves out of selling a company with deteriorating fundamentals.

In conclusion, I define risk in dividend investing as an event that leads to total destruction of capital, from which my dividend income would be reduces or eliminated. In order to reduce this risk, I am diversifying my portfolio, and have a hard sell rule of disposing of a stock after a dividend cut. This would protect my dividend income, and allow me to enjoy the fruits of my labor in my golden years.

Full Disclosure: Long KO and JNJ

Relevant Articles:

- Dividend investing timeframes- what's your holding period?
- Dividend Investors Should Focus on Valuation, not Just Dividend Yield
- Opportunity Costs for Dividend Investors
- High Yield Dividend Investing Misconceptions
- Replacing dividend stocks sold

This article was featured in the Carnival of Personal Finance, Back to School Edition