Many investors look for ways to simplify their quest for better results, and there’s perhaps no more set-it-and-forget-it method than the “Dogs of the Dow” approach.
This popular method involves simply buying the 10 highest-yielding Dow Jones Industrial Average stocks at the end of each year, and its proponents maintain it generates market-beating returns.
The question: Is this age-old practice out of touch, or does it still have merit?
How Does the ‘Dogs of the Dow’ Work?
As mentioned above, if you were going to buy the Dogs of the Dow, you would simply screen the Dow Jones components for dividend yield at the end of the year, then buy the 10 with the highest dividend yields. Currently, that would include familiar names such as AT&T Inc. (T) at 5.4%, Verizon Communications Inc. (VZ) at 4.6% and Chevron Corporation (CVX) at 3.8%.
Note: Yields as of 12/29/14
You then would hold those shares until the end of the next year, then rebalance this portfolio by buying shares in any company that breaks into the 10 highest-yielding companies while selling shares of those that have fallen out of the group.
It’s simple enough in practice. But why would you invest this way in the first place?
Dog Idea
The Dogs of the Dow approach was pioneered by Michael O’Higgins and detailed in his book co-written with John Downes, called Beating the Dow.
The idea is easy: The highest-yielding Dow Jones stocks will attract other investors, which then drives share prices of these stocks up. Part of the premise is that the Dow stocks are stable, reliable, high-quality investments — stereotypical blue chips — so if yields are high on these stocks and their share prices are relatively low, chances are that cheap valuation will be a temporary situation.
This approach takes the guesswork out of stock picking and selecting investments. It can be used as part of a larger portfolio (or even as a complete diversified portfolio if investors choose to go that way, though it’s pretty easy to make an argument against a portfolio of just 10 large-cap stocks).
The method has at its roots a traditional value-based thesis, with yield as a partial indicator of value. The stocks that have lower performance for the year see their share prices drop, which in turn drives up the yield.
The Dogs method is best used as long-term investing method, to provide an ample time frame to smooth out any subpar periods of time in the markets.
There is a simple elegance to it.
As far as what kind of returns you might expect: O’Higgins and other proponents of Dogs of the Dow investing maintain that this method has generated equal or better returns compared to the overall Dow of the same years. From 1957 to 2003, for instance, the Dogs of the Dow would have returned an average annual total return of 14% vs. 11% for the entire Dow.
Recent years haven’t always produced such high returns, however.
Objections
Critics of the Dogs of the Dow maintain it’s coincidental, or that it simply doesn’t work. One of several criticisms of the method is that it involves an apples-to-oranges comparison. Where the Dow Jones average is price weighted, the Dogs are equal weighted, which skews results. Another criticism is that O’Higgins used “backtesting.” This is where the methodology is constructed, and then justified by looking over a period of time that has already taken place before the method was actually employed.
Some also would maintain that dividend-based investing is less relevant today, since dividends are now lower than they historically have been in the market.
Then there is perhaps the biggest division among critics and proponents, which is that the method is an automatic one. For advocates of the Dogs, they say this takes the guesswork out of investing. But critics retort that investors are giving up judgment and qualitative analysis. They point out that in automatic investing, index funds can lessen your gains, as without selection you’re adding both good and bad stocks without discrimination to your portfolio.
Simple Elegance vs. Automatic
Whether investors feel they should use the Dogs of the Dow method or not often comes down to whether they accept or even prefer automatic investing to active judgment or not. If you decide to use the Dogs method, just as with index investing or any other tactic, you must accept that there’s no guarantee the results will be superior.
Moreover, you should resist the temptation to override the selections or tinker with the methodology — either it works or it doesn’t, but tinkering distorts the simplicity and makes the idea more difficult to properly implement over time. That’s why we prefer to select our investments using our own judgment. Most of us try to improve or maximize our investing results this way.
Again, it’s personal choice. If you like simplicity and favor a value-based approach, the Dogs of the Dow might be worth a shot. If not, there are plenty of other methods out there, including just using your own research and instincts.
Remember, different investing approaches are part of what makes a market.
As of this writing, Greg Sushinsky did not hold a position in any of the aforementioned securities.
