Slow but Steady Wins the Race

There are actually two ways to make money in stocks — price appreciation and the dividend yield. And while dividend yields on both the Dow and the S&P 500 remain near record lows of around 1.8%, they're still enough to make a big difference in long-term returns.

Say you bought the Dow back in 1975, when the last bear market was finally starting to bottom out and the dividend yield was 6%. Based on price appreciation alone, the index would have returned 1,526%. Not bad. But factor in the dividends and that number jumps to 4,198%.

Same story for the S&P 500. On price alone, the index returned 1,574% over the 26-year period ended Dec. 31. But factor in the dividend yield to get the total return, and that number jumps to 3,956%. When it comes to actual bottom-line dollars, you can't ignore the importance of a couple of extra percentage points of annualized profit.

As we always like to point out, there's a bullish and bearish argument for every market and strategy under the sun. From value to growth, technical to fundamental, small-cap to large-cap to midcap (wheeze) to microcap (pause for breath), from blue chips to red chips to poker chips, each investing style appears to have its own unique merits.

But as for me, I put a high value on things I can depend on — both in my life and in my portfolio. I crave consistency. But there's good consistency, and there's foolish consistency. And unfortunately, once most people begin to realize the importance of dividends or other types of consistent investment income, their immediate reaction is to rush out and buy the highest-yielding instruments. They buy the junkiest of junk bonds or the diciest of dividend-paying stock — a strategy that's more often than not a losing one. Bond issuers can default, and dividends can be cut. Even temptingly high double-digit interest couldn't save many investors from losing money in Argentine bonds.

Creating consistency in your portfolio isn't achieved simply by focusing on dividend-paying stocks, but by taking an income-oriented approach to the design of your asset allocation. While I'm not a raging bear, I am a staunch believer that real money comes not from a steadfast devotion to stocks, but by achieving consistent, absolute returns over long periods of time. Simply put, you've got to be a consistently good gambler.

While I can't deny that the stock market has averaged about 12% over the past 75 years, this "long haul" spiel is less about the merits of stocks as an asset class than the mathematical effects of compound interest over time. And steady, inflation-outpacing income is a key ingredient in creating the magic of compounding.

Sure, consistency is dull. You want sexy? How about the Amerindo Technology fund (ATCHX), whose managers claim to have "long been on record identifying the dominant trends in technology and their impact on the global economy." The fund racked up an 84% return in 1998 and an incredible 248% in 1999, but its long-term results, those that ultimately matter most, are nothing less than pathetic. According to the firm's Web site, after five years and the biggest bull market in history a $10,000 investment would have shrunk by over 25%. So it appears that there's a distinct difference between identifying the dominant trends in technology and their impact on the global economy and having a fund actually make any money.

When it comes to my philosophy of allocating assets, I start with the notion that the only point to invest in anything is to make money. I place a premium on assets I can depend on, because in order to grow capital you must first concentrate on keeping it. What financial big-shots refer to as capital preservation is nothing more than good old-fashioned savings.

The foundation of most portfolios, even those of relatively "aggressive investors," should consist of a diversified portfolio of income-oriented investments.

I prefer a three-scoop sundae of bonds, dividend-paying stocks and real estate, designed to outpace inflation with a minimum of volatility or risk of principal. After that come the more speculative bets, whose returns are the nuts, whipped cream and cherry on top. Nice, but you can't count on them. Trading returns aren't paid like a salary. They're concentrated, highly volatile and difficult to predict.

This is the trader's style of portfolio management. It favors smaller, concentrated bets, and is a much more prudent approach to allocating assets. Even if every single concentrated bet I make goes against me, the net effect will be somewhat muted by a sound foundation of aggressive income-oriented strategies. It's an approach that would make Ben Franklin and Albert Einstein — a couple of pretty smart guys who were both particularly partial to the merits of compound interest — nothing less than proud.

Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management, a Chicago-based hedge fund.

Have a question about trading, portfolio strategies or other issues in investing? Drop Jonathan an email and he'll consider it for discussion in a future column.