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Coolhand's Market Analysis

There is an Alternative

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I haven't posted a blog in quite some time. It's been on my mind to put something out there, but my time is limited between my regular job and my premium service. Still, it's something that I'd like to do more often, even if only on occasion.

I joined TSP Talk back in October of 2004. That means I've been around on this site for almost 10 years now. In that time I've made many friends and learned many things. One bit of knowledge I've acquired has served me very well and I'd like to share it with you. It isn't anything new. But I think it's something that is overlooked by many people for various reasons.

In our quest to learn about investing and how to make money, we are bombarded by a seemingly endless stream of information that runs the gamut. It is, quite frankly, overwhelming for most people. Especially those with limited knowledge. And for all too many folks, investing can become a lesson in frustration. But before I delve into the reason why, let me differentiate the difference between "investing" and "trading".

Investing and trading are very different approaches in attempting to acquire wealth in the financial markets. When an individual "invests", he or she is trying to gradually build that wealth over an extended period of time through the buying and holding of stocks, mutual funds, bonds, and other instruments such as closed end funds. These investors often seek to increase their profits through compounding, and/or by reinvesting any profits and dividends into additional shares of stock or other financial vehicles. These investments may be held for a period of years, which has the advantage of accumulating interest and dividends and getting some stock splits along the way. This kind of investing requires investors to endure market fluctuations, but time has proven that riding out these ups and downs with interest and dividend type investments usually results in long term growth. It is also widely believed (and justifiably so) that dividend paying stocks generally trounce their non-dividend counterparts over time.

On the other hand, trading involves the more frequent buying and selling of stock, commodities, currency pairs or other financial instruments, with the goal of trying to generate returns that outperform buy-and-hold investing. Trading profits are generated a result of buying at a lower price and selling at a higher price within a relatively short period of time. The opposite is also true in that profits can be made by selling at a higher price and buying to cover at a lower price, which is known as "selling short". While dividend investors wait out less profitable positions, traders attempt to make profits (or take losses) within a specified period of time, often making use of stop loss orders to close out losing positions at a specified price point. Trading usually involves technical analysis tools, such as moving averages and oscillators, to find higher-probability trades (dividend investing may also involve technical analysis, although usually to a lesser degree).

Now that I have framed the general difference between investing and trading, let me ask you what is your desired approach? Generally speaking, investing is much less stressful and does not require nearly as much time if the investment approach is sound. You don't have to be tied to a computer.

But investing is not nearly as "exciting" as trading. This is something that I have learned over time. People tend to be drawn into trading rather than investing because it is more appealing at the basic level. We feel like we need to be doing something most of the time. Sitting on our hands is not something we like to do. But for most folks, that is probably what we should be doing because most people who get involved with active trading usually lose money over time. The knowledge curve to be successful is steeper than many realize.

Now, this blog is not about demonizing trading. It is only meant to make you think about what kind of approach makes the most sense for you. Any individual can be successful at either approach, but you have to decide what really might work for you and whether you have the time and/or the resources to engage it.

So, why invest in dividend stocks and other dividend paying financial instruments? Dividend stocks are stocks that pay dividends over a specified interval, usually in cash or sometimes in additional shares. By issuing dividend payments, a company distributes a portion of its profits to its shareholders every quarter (generally) and puts the remaining profits back into the company to fuel its continued growth.

When you receive a dividend, you are collecting interest on your money the same as if it was in a bank account. It's nice to see that payment hit your account, but as I said before it is not particularly exciting. "Betting" on the rise and fall of share prices is much more exhilarating, especially when your share prices soar. But dividend stocks offer several advantages over non-dividend stocks.

1. Dividends give you a steady flow of passive income, which you can either spend or reinvest (depending on the type of account you hold these stocks in).

2. Companies that pay dividends are usually more mature and stable and also tend to be larger organizations. Start-ups rarely pay dividends, because they use their profits to fuel additional growth. Many large companies began this way, but only when a company has attained a sustainable level of success does its board of directors decide (through a vote) to pay dividends. A company that issues dividends tends to be a company with a board of directors that is more accountable and not as prone to taking unnecessary risks.

3. A company that pays dividends tends to have a lower risk-to-reward ratio, which generally shows up as less volatility in the share price. A lower volatility usually means the company sees smaller share price declines when the market falls (although a stock can appreciate in a market decline too). By the same token though, low volatility can temper price appreciation as well.

4. Something that many folks may not have taken into consideration is that dividend paying companies are potentially poised to see growth as a result of more baby boomers reaching retirement age. These folks (I'm included) are looking for supplemental income beyond their pensions. Chances are very good there will be an increased demand for dividend stocks, which will also drive up the price. Now, nobody can predict with certainty that this will occur, but it does make sense.

5. Investing in dividend stocks gives you two ways to make money. Through dividends, of course, but also through capital appreciation. Non-dividend stocks only make you money if its share price appreciates. That's why dividends are so important. Even if a dividend stock's share price falls (usually temporarily), those dividends help offset that temporary loss. This is how dividend paying stocks outperform non-dividend paying stocks over time. Usually, by a wide margin.

6. One of the aspects of non-dividend paying stocks that many investors find frustrating is that owning shares in those stocks means profits remain in that stock. You can only access them by selling shares. By contrast, dividend stocks allow you to keep your shares, but still collect some degree of a regular profit through dividends which are usually accumulated in a cash account.

7. When you buy a given number of shares of a non-dividend company, you obviously get that number of shares. And if you want to buy more shares, you have to use your own resources to pay for them. With a dividend stock, as you accumulate dividends in your cash account you can eventually purchase additional shares of that company or another without using other resources. Of course, if you are a regular contributor to an IRA account, those contributions get added to the dividends you are receiving, which dramatically increases your buying power.

8. Inflation is something that will impact your earnings. If you have annual earnings of 20% in a non-dividend paying stock and inflation is 4%, you are effectively left with a 16% gain. But a dividend paying company can help off-set that inflationary element. If you owned a utility company that was paying a 5% dividend, then that 16% annual gain turns into a 21% annual gain after inflation. Also, as companies charge more for their products (as a result of inflationary pressures) their earnings may also increase, which often leads to higher dividend payouts.

9. One more reason to invest in dividend paying companies is the potential for eventually entering a bear market. In a bear market, when share prices are flat or falling, dividend companies usually continue paying dividends. And those dividend payments continue to offset losses from a potential drop in share price and still give you the chance to earn a positive return. I use this particular example of the benefits of dividend stocks when comparing how that bear market impacts those who are retired, but still retaining their TSP into retirement. Now this is something you will have to discuss with a financial planner, but TSP does not pay dividends (in general). At least not regular dividends. And if you are taking distributions from that TSP account in a bear market, you may be losing capital at a faster rate than you expected. This is a very serious issue if that retirement account is to last you a given number of years. If you take nothing else away from what I have been discussing in this blog, take this one seriously and get some financial advise about how to protect yourself in retirement. It is not as simple as some might think. But I recommend using a "fee only" financial planner and not a large company adviser who is looking to sell you a whole lot more than advise.

So what I have shared with you today is meant to make you think about where your investment or trading goals may be taking you. Over the years I have learned to become primarily a dividend investor, although I do some trading on the side as well (just not nearly as much). It is why I chose to couple a dividend investment model portfolio as part of my premium service rather than a trading platform as I believe the more conservative folks among us would find it much more appealing than trading (especially with leveraged instruments, which can be emotionally draining and costly if not successfully executed).

Again though, I post this blog not to disparage trading, but to inform you of other alternatives such as dividend investing. How you approach the market, especially into retirement, can be the difference between a successful retirement or a stressful retirement. My model portfolio has been very successful the past year. Virtually every stock that has hit my buy price is up over the past year. All while paying dividends too. In fact, I sold Covidien (COV) recently after a profit in excess of 50%.

But remember, dividend investing requires patience. And building a portfolio takes time, even if you have money readily available. The last thing you really want to do is dump your funds into the market at one time. It is much more advisable to buy your stocks and funds selectively when they are at a good value. And in this bull market, which has not seen a meaningful correction is quite some time, it can test your patience when trying to find those undervalued gems. But I am always searching for new investment opportunities and adjust my model portfolio by adding new stocks or funds over time.

I hope this was an informative blog. Thanks for taking the time to read it. I wish you every financial success.

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Updated 07-07-2014 at 03:11 PM by coolhand

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