There are ways to wrestle with the volatility of the total stock market. One way is dividend investing. The idea is a very good one, and more perhaps in line with our thinking, because it's a strategy that doesn't ignore that we are mere humans, and doesn't suppose super-human tolerance with volatility, as a 100% stock-market approach seemingly does.
If one is starting from scratch so one has lots of future cash flow coming in from one's salary to use to damper the volatility of the markets, this might be one of the quicker path to financial independence. If one happens to hit a good 10 year stock market-run.
We still want to raise a very serious warning, though.
It's not sure that the risk one is really taking on in the overall dividend portfolio has the best price. And one would need to be sure that one can stay very stoic, almost prone to self-hypnosis, during tumultuous times. Dividend investing still relies on a complete stock-only portfolio, with its grueling volatility. One important idea behind dividend investing is that one must rely on a very specific Yedi-mind trick to survive.
We think that quite a few have gone into dividend or full-stock-exposure, without really reflecting on if they are able to do that mind-trick.
But as long as one knows what one is in for, dividend investing has its charm.
Let us explain.
How to Wrestle Volatility with Dividend Investing
The simplest way to achieve a dividend strategy is to buy broad index ETF that pays out the dividends as cash.
If one is brave, and sure that one will be able to spend much, much time keeping an eye on particular stocks, one can also cherry-pick stocks with a future potential for dividends and a good price per earnings-ratio, stocks that have a good proportion between the price one pays to own the stock and the dividends they pay out.
A compromise might be to buy a broad value-ETF with dividends payed out in cash.
Stock cherry-picking comes with so many risks that we don't even want to start counting them, let's only mention the adage that the easiest person to fool is usually oneself.
Whatever way one choses, one intend to live off the dividends and stick with the same stocks, and strategy, for a long time - perhaps forever. Be it from the low-priced index fund or cherry-picking stocks that one hopes has a good future dividend (earnings) potential.
Hence one can concentrate not so much on the day-to-day or year-to-year valuation of the portfolio, but put one's mind at ease by concentrating on the dividends, which usually are much less volatile than the stock valuations.
Mental Accounting
So, as you, wise reader has already observed: by splitting one's focus on two different things, one can put one's mind at ease (supposedly) when the valuation of the portfolio itself gets cut in half and takes ten years to return.*
Mentally, one imagines that the money from dividends are different from the money from portfolio appreciation. Hence, by mentally accounting for the dividends as separate from the appreciation, one gets a virtual stream of money that has acceptable volatility. The money one earns is, so to speak, split into two accounts.
This is where the mental accounting comes in.
One account doesn't move that much - the account with dividends; the mental account one dares to look at, and the other one, the portfolio valuation; there one shouldn't get upset if it swings.
One needs to be able to look to the right (the dividends) and ignoring the left (the market valuation) to sleep well at night.
If one manages to pick good stocks, the dividend strategy might be one of the quickest ways to financial independence. It's s strategy that takes the price of what one is buying into the equation, and one that doesn't include totally wild speculation and pure fluke.
The Scent of Money
For us, as we saw it, it felt like too much of a mental trick to regard one part of the money as separate from the valuation of the portfolio.
And we have never been sure that we would be able to uphold that illusion in a longer market crash, or sleep well at night in times of much volatility.
We also think that we wouldn't have the time or interest to pick individual stocks, and that would expose us to risks; for instance that we let our emotions decide, and an evident risk of too large a home bias.
Another problem we saw was getting a good price on the risk one is taking on. Downside protection has always had more allure to us than a higher average return, and the higher risk would then need to be compensated with a fair amount of higher expected return.
Perhaps it doesn't matter so much if one stops the mental accounting, even if one of the basic ideas with dividend investing then disappears.
When one goes to the grocery store, the cashier will not care if the money one pays with comes from dividends or stock appreciation. It's just money.
And as Vespasian said, money doesn't smell.
Vespasian 17-79 AD, concerned with smell.
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