My Investment Philosophy – Index Funds and Stock Picks, Growth to Dividends

My investment philosophy focuses on building the portfolio that’s right for us by using both index funds and individual stocks. It focuses primarily on growth and dividend growth investing.

Investing wisely is something I often reference as key to achieving financial independence, especially without a huge income. Writing down your investment philosophy can be extremely helpful, even if you don’t follow it perfectly. I hope you will find mine useful.

This will serve as an introductory and key reference post to a number of future posts about why we own the companies that we own. I apologize for the length, but I hope it will be worth coming back to again and again.

Disclosure: I own all of the companies listed below. This is not a recommendation to buy or sell them. I’m not a financial adviser. Always research on your own before investing your hard earned money.

Long-Term Investment Goals

Our long-term investment goal is to have the option to retire early and live primarily off dividends before we grow too old to enjoy spending money and time with our family.

We’d like to be able to help our kids with their college, give generously to causes we value, and leave some money to our kids and grandkids.  We’d like to travel, volunteer, fish, and maybe work part-time for fun.

We’re currently in our early 30s, so we have plenty of time for downturns and upswings. If you’re closer to retirement, I would expect you to maybe take a more conservative approach.

With that in mind, we’re focused on total return during this accumulation phase of our life. I don’t care if my 6-10% average return comes from 1% dividends + 7% price increase or 5% dividends + 3% price increase. Either way, dividends are reinvested, and my total return is 8%.

As we get closer to retirement, we plan to move from more of a growth/dividend growth philosophy towards a dividend growth/ dividend plan.

investing plan

Invest in Index Funds or Pick Stocks

I’m a huge fan of investing in low-cost index funds. My 401k is 100% invested in Vangaard index funds. I choose index funds primarily because of their low fees and likelihood to beat most mutual funds.

I love that there is a war among investment brokerages to offer the lowest fees. I’m excited about Fidelity’s new zero-fee index fund.

I will always recommend index funds to new investors or people who aren’t interested in studying individual companies. If you want a hands-off approach, index funds are absolutely the way to go.

Index funds will outperform most high-cost mutual funds over time. These will earn you the same return as whatever market they are indexed to, generally the S&P 500, Russell 3000, or something similar.

Over the long term, you can expect an average return of 6% to 10% per year, with more up years than down based on history.

However, I believe that there is a time and a place for buying individual stocks. I fondly refer to these as our companies. We buy individual companies with our Roth IRAs and brokerage account. Combined, we have around 55% of our investments in individual stocks and 45% in index funds.

The question isn’t really index funds vs stock picking. The question is, what combination of index funds and individual companies works best for us. After all, an index fund is really just a basket of individual stocks. Stock picking allows us to customize that basket.

Why You Should Pick Stocks

Like most things in life, picking individual stocks has advantages and disadvantages. It isn’t for everybody. First, let’s look at why you might want to pick stocks rather than put everything in an index fund.

Owning individual stocks can produce higher returns. If I didn’t believe that I could regularly beat the market over the long-term, I would be a fool to choose individual stocks over an index.

Our individual stocks have outperformed the market each of the past 5 years. I say this not to brag but to say that it is possible and has worked well for us so far. I’m aware that we are in a bull market and probably won’t beat the market every year. It may be luck, but I put a lot of thought into the companies we own.

S&P 500

Buying individual companies is a great way to learn about investing and about business. There are few ways to learn better than dipping your toe in the water. I find this really fun and more exciting than following index funds.

Finally, owning a basket of hand-selected companies allows you to customize a portfolio that best fits your goals and values. Would you prefer income from dividends or faster growing companies? Do you believe in certain sectors of the economy more than others? Do you want recession resistant companies? Are there companies in the index you want to avoid?

Buying an index means you have less control over what you own. It is dictated by the index. If you need more dividends, too bad. Need less risk? Too bad. If you have moral objections to smoking, drinking, sweat shops, bombs, etc, you can’t just exclude those companies from the index; you own them if you own the index.

Invest Like You Own the Place

When we pull into the Target parking lot, I will say to my wife, “Shall we inspect our store?” We will walk around and comment on the store’s service, cleanliness, crowds, sales, atmosphere, etc…

We will notice which of our products are displayed in prime locations. “Ah, looks like our Disney (DIS) branded toys are selling well.” “I’m so glad we partnered with Chip and Joanna.”

As I open my parents’ fridge, I might say, “Thanks for buying our [Hormel (HRL)] turkey!”

When I swipe my Visa (V) card on the Square (SQ) iPad (AAPL) at the farmers market, I am proud to be using three of my companies at the same time.

Visa Apple

Invest like you own the place because you do. When you buy a share of stock, you are literally making yourself an owner of that company. As an owner, you should have a basic understanding of the company and be able to make the case for why you think it will outperform the market under your ownership.

This may seem silly when I own way way way less than 1% of any company, probably less than .00001% actually. However, this attitude is helpful as you think about buying companies for the long term.

Am I willing to pay $1,175 to own a single share of Google (GOOG) that doesn’t pay a dividend? Yes, yes I am because I think the price will keep growing 10-20% per year over the next 10 or 20 years.

What Types of Companies We Buy

We buy mostly growth and dividend growth companies. We will also buy companies that we perceive to be significantly undervalued when the market overreacts to bad news.

I don’t believe the markets are rational. They are what they are, but they oftentimes overreact to short-term news, analyst opinions, or even earnings reports.

Target is an example of this when it dropped more than 10% on news of Amazon merging with Whole Foods. You also could have bought it before that at either of the other drops from earnings reports or random negative news and still be doing well.

Amazon Whole Foods Target
Temporary bad news presented a great opportunity to buy Target.

We would prefer all of our companies be undervalued when we buy them, but a lot of great companies are “fairly valued”. If they are great, the return will follow. I don’t shy away from buying a company I believe will continue to be successful just because it is fairly valued.

As Warren Buffett famously said, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

This is one reason why I own Visa, Mastercard, Google, and Apple among others. If I had waited for them to go on sale, I may have never bought them. They don’t go on sale often.

Growth and Dividend Growth Investing

Our growth companies consist of companies I see dominating much of the world over the next 10-20 years. They are mostly tech, financial technology, or Chinese companies. I will spend more time looking at some of these mega-trends in upcoming posts.

These growth stocks generally pay little or no dividend, so I am anticipating I will make my return via capital gains in the future.

On the other hand, the dividend growth companies are generally more established companies with a strong history of paying a growing dividend. Even though they are established, I must have a reason to believe they will continue to grow into the future. If they stop growing, eventually the dividend will stop too.

I want the payout ratio to be below 60%, and even above 50% sends out some red flags. I don’t like a ton of debt though some is fine if they are generating plenty of cash.

The sweet spot for dividend yields on these seems to be around 2% to 4%. Some companies struggle to keep it above 2% due to the stock price rising too fast. This isn’t a problem that bothers me. If a company is growing its dividend 15% per year and its price 20%, who am I to complain.

On the other hand, a yield above 4% generally seems to correspond to a stock either having limited growth or being undervalued. I like undervalued; slow or no growth, not so much.

Let Your Winners Run

Let’s say you’re going fishing and catch three nice fish in a row. Are you going to suddenly switch your bait?

Maybe you’re a football fan. Your running back is averaging 15 yards per carry. Are you suddenly going to switch strategies and stop running the ball?

In most things in life, we try to reward success. If we see something doing exceptionally well, we encourage more of it. We say, “Keep doing that. More of that.” At our house, we often say, “Don’t mess with a happy baby!!”

However, investors have a weird habit of encouraging diversification away from great investments. Nobody will say it quite like that, but it is what it is.

When they say it, they make it sound so smart: “Rebalance your portfolio each year.” Ken Fisher in The USA Today said, “If you hold more than 5% of your total portfolio value in any one stock, it’s too much. Trim it.”

This completely undermines growth investing where you hope a few of your growth companies will substantially outperform the market over the next 10-20 years.

You know those crazy charts that show how great you’d be if you had invested in Apple in 1985 or Amazon in 2000? The truth is most of those people other than employees would have sold it after it doubled, tripled, or became a ten bagger. Most wouldn’t let it grow by 100 times because it would be 80% of their portfolio. Never mind the fact that their portfolio would be worth 10 million dollars.

Yes, selling half of it after it doubles in a year locks in gains (and selling high is good), but what are you going to invest your gain in now if you’re still in the accumulation phase? Probably something with a lower return. There are good reasons to sell but winning isn’t one of them.

Diversify

You should diversify. Wait, didn’t I just say not to diversify? Nope, that’s not what I said. Nuance my friends, nuance.

Diversification is important. Notice, I said let your winners run. I didn’t say to dump all your average performing stocks and put the money towards your winners. I didn’t say, “Deploy all new capital towards winners,” though you may want to add to them on drops.

Letting winners run simply means don’t automatically sell the winners just because they have a big gain. There are valid reasons for selling winners. Them being winners isn’t a valid reason though.

Perhaps you no longer believe in the thesis of the company. There could be new competition, slowing growth, or legal trouble. Maybe you are approaching retirement and want to transition your million dollar unrealized gain to $40,000 per year stable dividends. Those are good reasons.

Keeping 45% of our money in the 401k helps create automatic diversification, but we also own around 20 additional companies in various industries, various markets, and various stages of growth.

Tuition Isn’t Free

Unless you’re a lucky super genius, you will make some bad picks. Even if you are a lucky genius, your stocks will likely go down when the market goes down.

When I make investing mistakes, I call it tuition. Treating it as tuition helps me to mentally view it as a learning opportunity and not just attribute it to bad luck or forget about it. I’ve made a fair amount of mistakes, especially when I was starting out.

I actually keep one share of JC Penney in my portfolio to remind me of the mistakes I made with it.

It’s far better to make mistakes when you’re just starting out as they’re far less costly. A $500 mistake when you’re starting out can feel extremely painful, especially if you’ve only invested $1000. However it is far better to have a 50% loss on a $1000 investment when you’re young than on a $100,000 mistake when you’re older.

Even if that $1000 does really well over the next 20-30 years, it is unlikely to be worth more than $20,000. That’s a lot of money but hopefully won’t make or break your retirement.

Here’s some free tuition from a few of my biggest mistakes:

Invest in companies you know. Understand how they make money. I remember thinking I was so smart investing in a couple of random Brazilian companies a couple years before they hosted the Olympics and World Cup, thinking those would be a boon for Brazil’s whole economy. Wrong.

High dividend yields are dangerous. The yield is calculated by taking the dividend divided by the price.

Yield = Dividend/Price  Let’s do a little math. Yield can go up 2 ways: Either the dividend goes up or the price goes down. Often, the yield is high because the price is falling and may keep falling. Then they cut the dividend, and it falls more (and you don’t have a dividend).

I did this by buying some dumb iron ore mining company with a 10% yield thinking it was a guaranteed 10% gain per year. Nope, breaking 2 rules doesn’t make a right.

Avoid Penny Stocks, Even if they’re $1.00. Sure a ten cent gain is a 10% gain, but a 10 cent loss is a 10% loss too. They are generally dying or middling companies.

Don’t try to catch a falling knife. The price is usually falling for a reason. Sometimes they fall too far, and become great values, but that isn’t easy to know. You better have a compelling reason for why it’s bottomed out before you throw money at it.

Invest in Great Companies. This sums up most of the rules. Invest in great companies. Great companies are great for a reason and will likely continue to be great. Look for consistent growth and good management. This will take you far.

Time is Money. It takes time for money to compound. If you’re planning to strike it rich in a few years, you’re probably going to be disappointed. You will be more tempted to make risky, foolish decisions.

(Read about The Rule of 72 to see how time and interest rates affect your return)

Maybe You Should Not Buy Individual Stocks

There are some significant potential negatives to choosing which companies to own. If you see yourself in these reasons, it might be better for you to avoid individual stocks or start with them being a smaller portion of your portfolio. There’s no shame in indexing; I index a significant chunk of my portfolio after all.

Individual stocks are generally more volatile than an index fund. If you are going to jump off at the first big drop, you are probably better suited for index funds. Stock picking requires a higher risk tolerance to avoid buying high and selling low. That said, it is possible to create a diverse portfolio of companies by buying them individually.

You must have a compelling reason and some conviction for why your companies are better for you than owning the index. They can and will produce lower returns than the market at times. If you sell them during these times, you will lose money.

Owning stocks requires some level of knowledge and paying attention. If you don’t want to check up on your companies every so often or don’t care to understand the business, indexing might be better for you.

Remember, even index funds go down sometimes. If you have a long time horizon, just hang on and keep adding (you get more for your money when they are down). A sudden drop is generally not the best time to sell.

Happy investing and keep growing!

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