In our financial life it is important to have objective. This week just gone I experienced some customers of mine who had an objective but didn’t follow it. Not following you objective may cause regret, but it can also cost you money.

My own investment objective has always been long term and I have so far been good at picking stocks and other investment product that long term have been good. When I say long term, then I mean that there has been time during my ownership where had I stopped my investment I would have lost a fair bit of money.

Back to my experience this week, what happened was that my customers got blinded by other factors and forgot their main reason they came to see me. This blindness will be the reason for making irrational decision. I myself was about to make a similar decision a few weeks ago, when I was about to sell some shares of mine due to underperformance, I got blinded by the short-term performance and forgot the reason I bought them in the first place.

This leads me to the next thing. To have objectives we need to have done some homework/research, without this we will be thrown around at the mercy of others, and just because someone thinks something is a good idea, doesn’t mean it is a good idea for you.

To finish this of it is good to have financial objective for the short, medium and long term. If we have this then we know what to do if a stock does not perform as planned.

DRIP stands for “Dividend Re-Investment Program”. Some listed companies have DRIP’s where dividends are automatically re-invested in more shares from that particular company and usually with no associated trading fees.

I have for example over a period of two years turned 100 General Electric shares into 105 shares by having the dividends (minus taxes) automatically re-invested in additional General Electric shares. Those 5 shares now obviously also contribute to the dividends I receive and re-invest. I am using the principle of compound returns to get ever-increasing dividends from General Electric whether they increase their dividends or not. So it is a great way of slowly but surely growing your portfolio if you can’t or don’t make regular cash contributions to your portfolio.Also, as pointed out in my earlier post about dividend investing in general, in a diversified portfolio capital gains alone usually do not make you rich, but re-invested dividends do.

I don’t know about other brokers, but E*Trade, the broker I use for my US shares, offers the ability to enrol any of my dividend-paying shares in a DRIP without me having to pay any trading fees when the dividends are re-invested. This means that my portfolio frequently contains fractions of a share as the dividends never buy whole amounts of shares. That is not a problem; I get dividends on the fractional shares as well.

When I originally planned this post, I was going to mention that regularly re-investing your dividends constitutes a bit of dollar-cost averaging (at the time I thought dollar-cost averaging was a good thing). Since then I have become more knowledgeable and I would claim that re-investing dividends constitutes a regular contribution.

So here is why I like DRIP’s:

• I get my dividends re-invested right away rather than having to wait until I have received enough dividends to make it worthwhile to make a “normal” trade.
• I don’t pay any trading fees
• I use the principle of compound returns directly on the shares that paid out dividends.

I was going to write about Dollar-Cost Averaging (DCA) as an investment method in preparation to a post about DRIPs (Dividend Re-Investment Program). But first I was going to find some good sources for information about it.As it is impossible to predict how the market is going to perform, DCA is supposed to be a method that lowers the average cost of the shares you buy by regularly buying shares whatever the price of the shares as opposed to buying shares for a lump sum.

With DCA, you regularly invest for a fixed amount of money. If the price of a share goes up, your fixed amount buys fewer shares; if the price goes down your fixed amount buys more shares. If you have a lump sum to invest, DCA says it is better to invest it by buying shares with it at regular intervals for a fixed amount of money rather than investing it in one go.

When my company takes a percentage of my pay and invests in a pension I am dollar-cost-averaging, but it can’t be any other way. The same is true when I take part in the company Employee Stock Purchase Plan (ESPP).

My short research (using Google) showed that a fair amount of academic research has shown DCA to, at best, to fare no better than lump sum investing, and at worst to be a myth.

So my own approach now is: When it can’t be any other way (pension plan, ESPP, DRIP) I am effectively dollar-cost-averaging, but that does not mean I following the DCA system. If I have a lump sum available, I generally invest the lump sum.

The next part of this post may make this look like a link-farm, but rather than take my word for it, I suggest you look at the following links. I must admit that I’ve got an overweight of anti-DCA links, I’m sure you can find some more pro-DCA links if you want to see more of that side of the story.

First, a more or less neutral link:

• Dollar cost averaging (Wikipedia)

Links describing and extolling the virtues of Dollar-Cost-Averaging:

• Dollar Cost Averaging: A Technique that Drastically Reduces Market Risk
• Dollar-Cost Averaging (DCA) (from Investopedia. Investopedia is a Forbes media company; I’m surprised it doesn’t have a short for and against discussion of the subject)
• Dollar Cost Averaging: Slow and steady wins the race (from Motley Fool)

Against:

• Mathematical Illusion: Why Dollar-Cost Averaging Does Not Work (academic discussion, but stiil readable, I recommend it)
• Does Dollar Cost Averaging Work?
• Dollar-cost averaging’s not all it’s cracked up to be (USAToday)
• The costly myth of dollar-cost averaging (MSN Money)
• Dollar Cost Averaging Will Not Protect You

Some blog posts reactions on Dollar-Cost-Averaging, mostly against:

• Dollar Cost Averaging: A Poor Way To Reduce Risk?
• Dollar cost averaging and assumptions
• Does Dollar Cost Averaging Work?

I just found this interesting stock tip about US stocks from the Danish business daily “Børsen“. Christian Blaabjerg, market strategist with Saxo Bank is quoted as saying (in my translation):
“In the last 30 years … one has been able to obtain profit if one bought American shares before Thanksgiving and sold again after Thanksgiving. It is irrational, but it is an effect one shouldn’t underestimate.”

Click here if you want to read the original article in Danish…

When considering which shares to invest in, many people primarily take into account what the capital gains will be, how much the share price will increase. Over time, I have found that I prefer investing for income, investing in companies that pay a decent dividend. I particularly prefer those shares that have a high dividend yield (dividend divided by share price = dividend yield). The dividend yield tells you how much you are earning on a particular share in dividends alone. The value is easily compared to what you would earn if the money was for example just sitting in a bank account. Many dividend-paying companies increase the dividend they pay over time causing your dividend yield to increase.Assume for example that you bought a share at 100, and the annual dividend is 5. The dividend yield is 5. Over time, the dividend is increased and some years later the company is paying 15 per share. If the share price is now 300, the dividend yield of any new shares is still 5, but on the shares you originally bought (assuming you still hold them), the dividend yield is now 15%. Even without the gains, that is a good return.

So why am I so keen on dividend investing? Looking back in time and with a long-term view, shares have mostly outperformed any other kind of investment, and dividend-paying shares have outperformed non-dividend paying shares. Taking a UK centric view, according to ABN AMRO, £1 invested in shares in 1900 would have become £161 by the end of 2006 on capital gains alone, but if dividends had been re-invested, you would have had ended up with £21,174.

Dividends usually mean the company in question is actually making money and steadily increasing dividends usually means that earnings are increasing. Interestingly, Enron paid a dividend, but compared to their reported earnings, that dividend was steadily becoming smaller. The accounts of a company can hide a lot of relevant information, but faking real cash is difficult.

So the trick is obviously to buy shares where the dividend is regularly being increased and where the dividend yield is high. To me, a high dividend yield on new shares is anything above 3. Unfortunately you can’t just blindly go after shares with a high dividend yield. The dividend yield increases as dividends are increased, but the dividend yield also increases if the share price falls. And it should be obvious that you don’t automatically buy a high-dividend yield share if the dividend yield is increasing because the share price is falling. You will first want to find out why the share price is falling.

Below you will find some links to webpages with more (and more detailed) infomation on dividend investing:

…dividend-paying stocks outperform the average stock, and stocks with rising dividends have, in most periods, ranked among the highest performers.

www.mhinvest.com

According to Ned Davis Research in Venice, Fla., Standard & Poor’s 500 Index dividend-payers returned a shade over 10% per year from Jan. 31, 1972 through 2005, while the overall index grew by 8.5% a year. (The non-payers returned a paltry 4.1%.)

www.financial-planning.com

There’s a good deal of research that shows dividend-paying stocks tend to outperform all other stocks over the long term, and they tend to do so while offering below-average risk to boot.

www.fool.com

Full disclosure: I subscribe to the Motley Fool Income Investor newsletter

One of the great dangers when investing in shares is to fall in love with a share and then following it through all its ups and downs and potentially following it all the way down. The first share I did this with was Intel. I bought some Intel shares at $18, held them all the way up to $80 a share and held them all the way down to $18 again. So I hadn’t really lost anything (unless you compare with other things I could have invested in). It sure would have been nice if I could have locked in the gains when the share was at its highest, but even selling when it was at $60 a share would have been great (as I’m writing this, Intel is trading at around $26-$27).

It is more or less impossible to know when the best time for selling a share is, but stop-loss investing can help you lock in the gains or, well, stop the loss, depending on what is happening to the share price.

There are several variations of stop-loss investing. The one I prefer is the “trailing stop-loss” and it works as follows:
You initially decide how far you are willing to let the price of a share drop from its highest value (while you hold it). Let’s say that is 10%. The purpose is to set a limit to how much you are willing to lose without setting a limit on how much you can gain. It also enables you to lock in any gains there may have been. Let me illustrate with some examples:

Example 1, the price of the shares you have bought starts falling immediately after you bought them:
You buy a share at 100 ($, £ or €, it doesn’t matter).
Your stop-loss value is 100-10%=90. As long as the price doesn’t drop below that, you keep the shares.
Unfortunately, the price starts falling, it hits 90 and you sell the share.
That wasn’t great, you lost 10, but you have limited your loss to 10.

Example 2, the price of the shares you bought first increases for a while and then starts falling:
You buy a share at 100
The price increases to 120. This is the new value from which you calculate your stop-loss. Your stop-loss value is 120-10%=108. As long as the price doesn’t drop below that, you keep the shares.
The price increases to 140. This is the new value from which you calculate your stop-loss. Your stop-loss value is now 140-10%=126. As long as the price doesn’t drop below that, you keep the shares.
The share price does start dropping, it hits 126, and you sell the share.
That was better than example 1, you could have sold at 140, but who knew that was going to be the highest value it would reach, and you have locked in a gain of 26 rather than potentially holding on as it falls even further.

I regularly calculate what the stop-loss values of the shares in my portfolio are, but I don’t automatically sell a share that drops below its stop-loss value. Doing that can give you losses even though it is supposed to minimise them.

Several years ago, I bought shares in Citrix. A few months later, the share price dropped 75% in one day (Microsoft announced that it would bring out Terminal Server, a product with the same features as Citrix’s). The drop in price was so sudden that stop-loss investing wouldn’t have saved my skin (unless of course the share price would have continued to fall). Two months later, the share price went back up to its previous level as Microsoft announced that Terminal Server would be based on Citrix technology.

In the recent sub-prime credit crisis, I bought some shares that had fallen and I considered them a good buy. Shortly after, they fell even further (by about 20%) as the market panicked and sold anything related to the financial industry. A few days later the shares went back up to previous levels as investors found that these particular shares did not have exposure to the sub-prime credit crisis, and when Ben Bernanke lowered the interest rate, the price rose even further.

On the other hand, as illustrated with my Intel example, there have been times when a share has given me very good gains on paper, and where I later have followed the shares downwards, in one case all the way to bankruptcy. Had I used the stop-loss approach, I would have locked in my gains on some badly behaved shares.

Summary:
I would suggest you regularly calculate a stop-loss value for the various shares in your portfolio. If the price does drop below your stop-loss value, consider selling the share, but don’t do it on auto-pilot. There could very well be valid reasons to keep it (maybe it pays a high dividend). Consider also, that stop-loss investing doesn’t tell you to get rid of a share whose share price is motionless.

I have made a small, simple spreadsheet that illustrates the approach; you are welcome to download it. You are even more welcome to enhance it.

Click to download: Stop-loss.zip