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Simple Advice for a Volatile Summer

If you watched my Stock Market Crash Course video on Friday, you know that we’re in for more volatility this summer. Volatile markets are stressful for many investors, who don’t like seeing their stocks bob up and down indecisively. Not to mention that a lack of direction in the...

If you watched my Stock Market Crash Course video on Friday, you know that we’re in for more volatility this summer. Volatile markets are stressful for many investors, who don’t like seeing their stocks bob up and down indecisively. Not to mention that a lack of direction in the overall market makes it very hard to commit to doing anything, whether buying or selling.

So I think now is an opportune time to reiterate some advice I gave here last November that proposes a unique, almost Zen approach to volatility. Here it is:

Investors hate volatility. Watching your holdings fly up and down, especially when they’re losing value, is agonizing—and makes it very difficult to make rational investment decisions. That’s why I frequently remind readers to take a step back from the market and try to ignore the day-to-day action of their stocks. But in the latest Dividend Digest, one of our contributors went a step further: explaining how investors can use volatility to their advantage. Or, as he put it in his headline: “Another Word for Volatility: Opportunity.”

One caveat: this advisor subscribes to Warren Buffet’s sentiment that the ideal holding period is “forever.” So this strategy is only for investors who really know how to take a step back from their investments. If you can’t go on a two-week vacation without checking your portfolio’s value on your smartphone, this is not the system for you.

Still with me? Good. Then here’s Mark Deschaine, editor of Deschaine & Company’s quarterly letter, Viewpoint, on how to turn volatility into opportunity:

“Most investors have a love-hate relationship with the stock market. They love it when the stock market’s going up or is at recent highs, but they hate it when it goes down or is trading at recent lows. ... Five years ago this month, the stock market, as measured by the Dow Jones Industrial, reached an all time high of 14,153. For those of you keeping track of such things, it was October 9, 2007 to be exact. In the meantime, the stock market proceeded to swoon to a low of 6,747 on March 2, 2009, in the middle of the now infamous credit debacle that has come to be known as the ‘Great Recession’—a drop of 52% from peak to trough. Needless to say, a drop of that magnitude scared the life out of a lot of investors. Since bottoming in March 2009, the stock market has rallied almost uninterrupted to once again close in on the all-time high.

“So how exactly are many investors reacting to the more than 100% increase in stock prices since 2009? Why, by selling stocks and heading for the perceived safety of record low-yielding bonds and bond mutual funds. Just in the last year, investors have yanked $150 billion out of stock mutual funds and put more than $1 trillion into bonds and bond mutual funds.

“One of the reasons investors are shunning stocks is because most stock investors haven’t realized anywhere near the 100% return in their stock portfolio that the market’s realized since 2009. That’s because many investors sold out of stocks after the market crashed in early 2009 and have continued their stock selling spree ever since. Let’s just say it’s hard to make money in stocks when you don’t, well, actually own stocks.

“Then again, as we’ve documented repeatedly, this is the nature and habit of the average investor: a long and less-than-glorious history of selling stocks at or near cyclical bottoms and buying them back again only after they’ve reached the top of a particular market cycle. It’s the very reason most investors fail at the task of investing in stocks. They react emotionally (out of fear) and sell after prices have fallen rather than take advantage of the market’s price volatility to buy more shares and add to their stock holdings at bargain prices.


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Another Word for Volatility: Opportunity

“Nowhere are the benefits of fluctuating prices more evident than the September 30, 2012, details for our Equity Income Portfolio, as shown in Table 2 below. Here’s what the table shows: Since 2007, the average dividend for an Equity Income Portfolio stock has increased by 75.9%, or about 12% annually. Compare that to the flat dividend growth for the S&P 500 index over the same period (in Table 3). What the table also shows is the five-year high and low dividend yield for each stock.

“In other words, if we had managed perfect timing when buying the individual stocks, and bought each one at its five-year low price, we would have locked in a dividend yield of 11.3%! Note, had we done a terrible job and bought each stock at its five-year high price, the dividend yield on the portfolio would be a meager 4.3%.

Dividend Data tables

“So ask yourself this question: which dividend yield would you rather your portfolio pay you every year: 11.3% or 4.3%? If you bought the stocks as of September 30th, the portfolio would have a $28.54 dividend yielding 5.3%. In addition, the EIP’s ‘Yield on Cost,’ that is, the portfolio’s dividend income divided by what we actually paid for the stocks, is a healthy 6.6%. That means that no matter what the stock market does, the Equity Income Portfolio will generate 6.6% in annual dividend income on our invested capital (and growing as the companies continue to boost their dividends).

“For the record, yield on cost would be higher but for the fact that we’re consistently adding to our share positions with dividend income to build future dividend income, in a sense, ‘watering down’ our yield on cost over time, while at the same time building our dividend income in real dollar terms. ...

“At the end of the day, you can either make price volatility work for you or against you, it’s really up to you. Since it’s never going to go away, it seems the logical thing to do is to make it work to our advantage. That’s what we’ve been trying to do in the Equity Income Portfolio since 2000. Doing our best to buy when individual stocks are cheap (or more accurately when their dividend yields are high) and refrain from buying when dividend yields are low.”—Mark Deschaine, Deschaine & Company’s Viewpoint, Third Quarter 2012

Deschaine’s advice is timeless—after all, his strategy pays little attention to what the market does day to day—but I thought it was an especially valuable reminder in today’s choppy market. Plus, it’s summer: wouldn’t this be a great time to be able to take a two-week vacation without worrying about the indices’ every twitch up and jolt down?

On that note, I hope all my readers in the U.S. enjoy some fantastic Independence Day celebrations this week and appreciate the freedoms we enjoy here.

Wishing you success in your investing and beyond,

Chloe Lutts Jensen

Editor of Investment of the Week

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Chloe Lutts Jensen is the third generation of the Lutts family to join the family business. Prior to joining Cabot, Chloe worked as a financial reporter covering fixed income markets at Debtwire, a division of the Financial Times, and at Institutional Investor. At Cabot, she is a contributor to Cabot Wealth Daily.