As they say, history often repeats itself. Hitler is literally being born again as you read this. Try and act surprised in about 40 years.
A lot people turn to historical trends when it comes to solving problems. At work, you talk to the old crusty guy who was around back when Agnes was typing up crap on a typewriter. When faced with all sorts of problems, folks under 40 ask their parents because apparently they know it all. Even new parents consult books written by doctors and other baby-type people to tell them what the hell to do with a slobbering cry/puke/crap bucket.
But when it comes to using history for a guide, nothing beats the average dividend growth investor.
I won’t spend time ragging on dividends. I’ve already done that. I’ll just say that your investing life will be much more interesting if you open yourself up to new stocks that don’t pay a dividend. If getting paid each quarter no longer matters, then you can focus on the important things — like the quality of the business and how much the market values it.
There’s a group of stocks called the Dividend Aristocrats. They’re a group of approximately 50 U.S. listed companies that have raised dividends for at least 25 consecutive years. As you can imagine, they’re considered to be the cream of the investing crop. Most investors would rather invest in companies that are consistently good, not in beaten-up small-caps. It’s just human nature.
And so they invest in the Aristocrats.
I don’t want to rag on the Aristocrats either. Studies have shown that the current set of Aristocrats have outperformed the S&P 500 by about 2% over the last 25 years, which is about as good as a mere mortal can do in the investing world.
So why am I not suggesting that you sell the farm and put all the cash into Coca-Cola? Because of two little words — hindsight bias.
Biases can be detrimental to your finances. We tend to think the stuff we’ve done is the best, even if the actual case is debatable. Somebody might think paying off 0% interest is a good deal, while others who are better at math wouldn’t put such a high priority on paying off free money.
We also tend to think whatever way we’ve picked to invest is the best. I think a value method is the best, while some of you reading this might think indexing is best. I know there’s at least one guy who feels the need to point it out in the comments. Dividend growth investors are probably going to think their way is the best.
So what do we do? We seek out evidence that supports our theory.
Which is why backtesting your portfolio is so useless. I’ve read dozens of articles that look at the results of a dividend growth strategy over certain periods of time. And surprise, surprise, they all tend to outperform the S&P 500. Most magically exclude former dividend growth stars like Pfizer, BP, and pretty much every financial from from any backtesting, which then “proves” that dividend growth investing is superior.
Anyone with a brain can figure out the problem with that logic. It’s easy to pick a portfolio of winners after the fact. That’s like me asserting that the 2014 San Antonio Spurs were a good basketball team 62 seconds after they beat the Heat in the finals. My assertion after the fact isn’t very meaningful.
That’s exactly what investors are doing when they do a backtest of a portfolio when they already know the result. They’re not looking for hard evidence of whether their portfolio will work in the future, they’re just looking for some sort of justification that they’re right.
Figuring out that the last group of dividend aristocrats outperformed the market isn’t that hard. Figuring out that Wal-Mart was going to be the biggest retailer in the world back in 1985? That would have been much harder. It’s easy to pick winning stocks if you already know they’re winners. But will they really stay winners?
In 1985, K-Mart was the dominant discount retailer in the U.S., while Sears still controlled the more upscale market. Wal-Mart had 1,200 stores (compared to 7,100 today) and Target had 226. Who would you have bet on to be the most dominant discounter in 30 years — Wal-Mart with 1,200 stores, or Kmart with 2,050?
The thing the dividend investors won’t tell you is that the Aristocrats list is constantly changing. The current list is the best of the best because all the crap has been dropped out. As current companies struggle and get dropped from the list, good companies get elevated to the top.
Essentially, by saying Dividend Aristocrats outperform the market, all you’re saying is that good companies outperform poor ones. True, but that doesn’t really help us find good companies now, does it? Over time, most Aristocrats tend to stumble.
Backtesting for value strategies is a much safer practice. It’s easy to blindly pick all the stocks that traded under book value and see where they stood a year later. There are still issues with it, but that has more to do with screening. There’s no way to account for a company like Hudson Bay which technically doesn’t trade under book value, but in reality is trading at a big discount to intrinsic value.
Anyway, don’t just backtest your strategy. It’s not very useful. Give a company credit for what it has done in the past, but then focus your attention on the future of the business. That’s infinitely more helpful than looking at the performance in the past.