Last week, I posted "Your Retirement Plan Is Probably Wrong" which, as you can imagine, generated much debate. One of the more interesting rebuttals was the following:

"'The single biggest mistake made in financial planning is NOT to include variable rates of return in your planning process.'

This statement puzzles me. If a retired person has a portfolio of high-quality dividend growth stocks, the dividends will most likely increase every single year. Even during the stock market crashes of 2002 and 2008, my dividends continued to increase. It is true that the total value of the portfolio will fluctuate every year, but that is irrelevant since the retired person is living off his dividends and never selling any shares of stock.

Dividends are a wonderful thing, Lance. Dividends usually go up even when the stock market goes down.

A person living off his dividends during retirement and never spending the principal will be able to enjoy a financially secure retirement. The secret for the investor is to focus on dividends. A consistently rising dividend income stream will provide the investor with a financially secure retirement."

This comment drives to the heart of the "buy and hold" mentality (even the author's handle is 'buyandhold2012') and along with it many of the most common investing misconceptions.

Dividends Always Increase, Right?

Let's start with the notion that "dividends always increase."

That notion is true, until it isn't. During the 2008 financial crisis, more than 140 companies decreased or eliminated their dividends to shareholders. The table below shows the closing price, yield and annual dividend as of the end of 2007 as compared to today. (The list excludes companies that became insolvent, merged or were acquired.)

Yes, many of these companies are major banks, however, leading up to the financial crisis there were many individuals holding large allocations to banks for the income stream their dividends generated. In hindsight, that was not such a good idea.

While I completely agree that investors should own companies that pay dividends (as it is a significant portion of long-term total returns), it is also crucial to understand that companies can, and will, cut dividends during periods of financial stress. It is likely during the next major market reversion we will see much of the same happen again.

Valuation Risks

Over the last six years, as the Federal Reserve artificially suppressed interest rates, the push of capital into financial assets has lofted prices to historic levels. However, one of the side effects of suppressed interest rates was a "chase for yield." As shown in the table below, I scanned the S&P 500 only for those stocks paying a dividend and compared them to the end of 2007.

If you scroll to the bottom of the table above, you will see the average and median valuation for these stocks for the end of 2007 and today.

The yield chase has pushed both the average and median valuations of dividend yielding stocks to levels higher today than at the previous peak. While this does not mean that a "crash" is imminent, it does suggest that during the next "mean reverting"event investors will likely find little relative "safety" in dividend yielding stocks.

Psychology

Of course, while the commenter suggests that he will remain steadfast to his discipline over the long-term, repeated studies show that few individuals actually do. This was shown clearly in a recent Dalbar study that I discussed in "Why You Suck At Investing:"

"However, even the issues shown above do not fully account for the underperformance of investors over time. The key findings of the study show that:"

• In 2014, the average equity mutual fund investor underperformed the S&P 500 by a wide margin of 8.19%. The broader market return was more than double the average equity mutual fund investor’s return. (13.69% vs. 5.50%).
• In 2014, the average fixed income mutual fund investor underperformed the Barclays Aggregate Bond Index by a margin of 4.81%. The broader bond market returned over five times that of the average fixed income mutual fund investor.(5.97% vs. 1.16%).
• In 2014, the 20-year annualized S&P return was 9.85% while the 20-year annualized return for the average equity mutual fund investor was only 5.19%, a gap of 4.66%.
• In 8 out of 12 months, investors guessed right about the market direction the following month. Despite “guessing right” 67% of the time in 2014, the average mutual fund investor was not able to come close to beating the market based on the actual volume of buying and selling at the right times.

"Accordingly to the Dalbar study, the three primary causes for the chronic shortfall for both equity and fixed income investors is shown in the chart below."

"Notice that "fees" are not an issue. The real problem for individuals comes down to just two primary issues: a lack of capital to invest and psychology."

Despite the logic behind "buying and holding" dividend yielding stocks over the long term. The biggest single impediment to the success of that strategy over time is psychology. Behavioral biases that lead to poor investment decision-making is the single largest contributor to underperformance over time. Dalbar defined nine of the irrational investment behavior biases specifically:

• Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time.  Also known as "panic selling."
• Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
• Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
• Mental Accounting – Separating performance of investments mentally to justify success and failure.
• Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
• Herding– Following what everyone else is doing. Leads to "buy high/sell low."
• Regret – Not performing a necessary action due to the regret of a previous failure.
• Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
• Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

The biggest of these problems for individuals is the "herding effect" and "loss aversion."

These two behaviors tend to function together compounding the issues of investor mistakes over time. As markets are rising, individuals are led to believe that the current price trend will continue to last for an indefinite period. The longer the rising trend last, the more ingrained that belief becomes.

However, when the markets decline, there is a slow realization that "this decline" is something more than a "buy the dip" opportunity. As losses mount, the anxiety mounts until individuals seek to "avert further loss" by selling. When it comes to dividend yielding stocks, that psychology is no different - a 3% yield and a 30-50% loss of capital are two VERY different issues. As shown in the chart below, this behavioral trend runs counter-intuitive to the "buy low/sell high" investment rule.

In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision-making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.

While many studies show that "buy and hold," and "dividend" strategies do indeed work over very long periods of time; the reality is that few will ever survive the downturns in order to see the benefits. Furthermore, with valuations and market correlations at extremely elevated levels, the next major market correction will be equally unkind to all investors. But then again, since the majority of American's have little or no money with which to invest, maybe that is the bigger problem to begin with.