In our series on income investing so far, we’ve discussed a few things, for instance, what it is, how it differs from growth, who it is for, tips on how to balance risk and reward, and DRIPs. Today we decided to step away from what you should be doing and instead decided to focus on what you should not be doing.
Everyone makes mistakes, and income investors are no different. Today, we highlight six common investing mistakes that income investors make and offer practical and realistic ways for you to avoid them. Spoiler Alert: Most of these mistakes stem from two mental biases that impact several of us (and I include myself in this number):
- We assume (and act like) yield is the same as quality, and
- We think that income is different from total return.
In both cases, this is not true. Yield is not a proxy for quality, and income is mathematically no different from total return, though it may feel like free money. I’ll explain more in each point, so let’s jump right into it.
Common Mistakes Income Investors Should Avoid:
Mistake 1. Chasing the Highest Possible Yield
Say you come across a stock that you love. Why do you love it? It gives you a 10% dividend yield while the rest of its sector averages 5%. You jump for joy and buy as much as you can and live happily ever after. Right? Maybe, but the smart money is on you getting burnt. It could be that this stock could head for a dividend cut. In the words (with one additional word courtesy of yours truly) of the incomparable Admiral Ackbar, “It’s (maybe) a trap!”
What to Do? Avoid the Yield Trap
A yield trap could indicate underlying financial risk that may force a dividend cut. As with most things, this is not a guarantee. You need to do your due diligence, check the stock’s payout ratio, free cash flow coverage, and debt situation. If the yield looks too good to be true, it could be that it is.
Mistake 2: Overconcentration in Canadian Banks, Energy, and Telecoms
Look, I get it. I also love Canadian banks, and telecom, and while not all energy is created equal, I cannot argue with the yields there either. It is tempting to load up on these sectors, but it is a problem for Canadian investors, especially because our equity market is already concentrated in favour of energy and financials, while underdeveloped in growth sectors like technology and healthcare. Add to that, banks, energy and telecom are also co-related in a lot of ways, so the concentration becomes even more, not to say anything about the home bias that impacts all investors.
What to Do? Diversify
We’ve talked before about diversification being the only free lunch in investing, and it is certainly important to diversify. And this means across the board. Look at the sectors you have, and try and shop for securities outside those, so that you can get the benefit of diversification, and look outside Canada for more options.
Mistake 3: Thinking Dividends Are Free Money
We have a detailed piece on the biases investors have around dividends, but in short, no dividends are not free money. You (and me too, I must admit) feel that it is so because your mental accounting system tells you that you got money without selling = free. This could make you buy more dividend players, while ignoring growth opportunities that would give you a better total-return.
What to Do? Treat All Stocks As Equals (At Least in Analysis)
No, dividend paying stocks are not some magical fairies that get to be in their own secret world with no scrutiny. Analyze your entire portfolio by the same standards, and you might find that you are making excuses for some dividend payers that they might not fully deserve.
Mistake 4: Panic-Selling or Doubling Down After a Negative Announcement
Sometimes bad things happen. Dividend cuts could be announced, or payments could get eroded. Here’s a detailed article on what to do when bad news hits your stock, but I can tell you, panic selling or stubbornly holding are not the only two options. In fact, both those options might be bad for you. It feels like the world is ending when this happens, but that is because of a behavioural driver called “Loss Aversion,” which is when pain is felt worse than similar joy. The bad news is that nothing can fully take that pain away, but the good news is that once you know about it, you can take steps to protect yourself and minimize it.
What to Do? Be Disciplined and Stick to the Plan
You should always have a financial plan that is backed by specific financial goals. Ideally, this plan should have been in place before you bought your first stock, but the second best time to do it is immediately. When you have a plan, it does not necessarily matter what is happening in the market, you know when you must sell, or buy, and short term pain is just that – short term.
Mistake 5: Gambling
This is not an income-investor only phenomenon. All investors may feel a fear-of-missing-out (FOMO) when they see the hot new trend. But remember, sometimes meme investing could burn you, badly. You are feeling the way you feel because of a behavioural trait called “Recency Bias,” where you assume that whatever happened recently will continue, whether it is up, or down, and the stock that is currently in the news will stay that way. This is rarely a sound investment idea.
What to Do? Have a Portfolio Rebalance Schedule.
Like the fix of the previous mistake, you may want to consider establishing a regular schedule for reviewing and rebalancing your portfolio. Ideally, make any significant investment decisions or portfolio changes during these planned review dates rather than reacting to FOMO and short-term market movements.
Mistake 6: Overconfidence
Are you the next Warren Buffett, or did you just get lucky? If you think you are the greatest stock picker ever, you’ll get increasingly convinced of the idea and could end up making some costly errors.
What to Do? Analyze
Keep a record of why you bought a particular stock. And use it to humble yourself and remind yourself that you did a lot of work. Luck might have played a hand, mixed with skill and other things. If you know how you won, it could be easier to avoid the problem of thinking you’re always right.
It’s Not You, It’s Everyone
If you have made these mistakes and are beating yourself up about it, remember this: Every single investor has made mistakes at some point, yes, even Warren Buffett. If you think you’re better than the Oracle of Omaha, then maybe you should reread mistake number 6, but if like the rest of us, you’re feeling bad, don’t! Every mistake is a learning opportunity, and we will always do better! Until next month, Happy Investing!
Disclaimer
The views and/or opinions expressed above are of a general nature and are for informational purposes only. The contents should not be considered as advice and/or a recommendation to purchase or sell the mentioned securities or used to engage personal investment strategies. Investors should consult their investment advisor before making any investment decision.
Commissions, management fees and expenses all may be associated with investing in Harvest Exchange Traded Funds (managed by Harvest Portfolios Group Inc. (the “Funds”). The funds are not guaranteed, their values change frequently and past performance may not be repeated. Please read the relevant prospectus before investing.
