Today, I want to channel my inner pessimist and wax apocalyptic.  It’s time to imagine some financial scenarios ranging from bad to abysmal. Today is all about losing money, and lots of it.  Why?  Because risk is inherent in every investment.  Unless we understand those risks, anticipate them, and prepare for them we are positioning ourselves for disaster.  Go get yourself a stiff drink and box of tissues, because financial sadness awaits us.

While all of the below models and disaster scenarios are based upon a dividend growth stock portfolio, it should take relatively little mental effort to imagine how they could be applied to index funds or ETFs.

Starting Points

In order to begin imagining the worst case scenarios, we need to lay down some basic assumptions that will be the starting point for the upcoming financial Ragnarok.

 

Starting Portfolio (the victim)

• $1,150,000 portfolio.
• Diversified equally over all 10 S&P500 sectors
• 3.5% dividend yield, resulting in ~$40,000 per year of dividends.

 

Basic Assumptions

• Dividend cuts come with rapid drops in the price of the associated stock.  So you’re not just going to be out the dividend stream, you’re also going to lose capital.

 

Types of Damage

• Loss of dividends from one stock - The most frequent problem that you will face as a dividend investor.  This has happened a lot throughout history.  Most recently and spectacularly with BP following the Deepwater Horizon accident.
• Loss of dividends from one sector (or 10% of your dividends) - This is a less frequent, but very damaging problem.  This happened back in 2008/2009.  Remember such companies as Bank of America (BAC), Citigroup (C ),US Bancorp (USB) and Wells Fargo (WFC)?  Those companies used to be dividend paying darlings, loved by investors the world over. If those companies comprised most or all of your financial sector holdings, you got hammered.  Some, such as BAC, still haven’t recovered either their share price or their dividend stream.
• Loss of dividends from two sectors (or 20% of your dividends) - Let’s just kick the pessimism up another notch and assume that 20% of your dividend stream takes a hit. This might be because economic conditions take down two sectors simultaneously or because you over invested in one sector.  Regardless, 20% of your dividends are now toast.
• Nightmare - For those times when losing only 20% of your portfolio would be considered a blessing.

 

Dividend Disaster Scenarios

Dividend Cuts

No company has to pay out dividends to common stock holders.  Rather, the company chooses to.  Dividends can be reduced, or eliminated at any time for any reason.  Companies with a long history of increasing dividend payments tend to be very reluctant to cut their dividends on a whim.  However, should a company find itself in trouble, common stock holders and their dividends are pretty low on the totem pole of investment classes, behind bonds and preferred stocks.

So why might a company cut its dividends?  Usually in response to declining sales.  But companies can also cut dividends in order muster the cash to acquire another company or make some other major purchase.  Dividends may also be in jeopardy when a company is bought up, enters into a merger, or splits into separate companies.

Major accidents, such as BP’s Deepwater Horizon oil spill, may also prompt a dividend cut.

When one company cuts its dividend

When my dividend growth portfolio is complete, I hope that it will be spread roughly equally over 30 to 40 securities.  To understand why this is advisable, let’s consider the following four portfolios, a 10 stock, 20 stock, 30 stock, and 40 stock portfolio handle a dividend cut from just one company.  In this scenario, I’m going to assume that the dividend cut is due to a serious business failing, so all the capital invested in the stock that cut its dividend is gone.

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When 10 or 20% of holdings cut their dividend

As the number of failing companies and thus the number of cut dividends increases, the less protection diversification can provide.  Below illustrates the same four portfolios responding to 10% and 20% dividend cuts.  Once again dividend cuts will be associated with a total loss of capital.

This is a bit unrealistic since these kind of massive shocks are usually due to major economic factors such as recessions rather than just the failings of one poorly run business.  A more realistic scenario would be a 50% capital loss on each stock that cuts its dividend.  But this article is all about pessimism!

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Brokerage Failure

Brokerage failure is the nightmare scenario where you can lose almost everything.

Your brokerage house is a company, just like so many others.  And just like every other company on the planet, your brokerage can lose money and even descend into bankruptcy and failure.  If that occurs, what exactly happens to all the money, stocks, and other equities you had sitting there?

It so happens that if your broker becomes insolvent an insurance program known as the Securities Investor Protection Corporation (SIPC) kicks in.  You are insured for up to $500,000 in securities and $100,000 in cash.  Some brokers even provide additional amounts of insurance.

While that sounds great, there are caveats. Importantly, you need to be able to prove that you actually owned shares in the brokerage.  So keep copies of those statements.

SIPC does not insure you against investment losses.  If you made a bad investment decision, you’re still going to be out of money.  Losses due to fraud are not covered either.  So if you fell for Bernie Madoff‘s scam, you’re out of luck.  SIPC also does NOT insure commodity futures contracts, currency, investment contracts (e.g. limited partnerships), and many fixed annuity contracts.

SIPC makes every effort to reimburse you share for share if possible.  So if you lost 100 shares of KO when your brokerage collapsed, SIPC will try to make you whole with 100 shares of KO.  It doesn’t matter if KO’s price collapsed and it cut it’s dividend, you’re still getting 100 shares of KO back.  And you better like it!

SIPC isn’t exactly fleet footed in its response either.  In the best case scenario, within one to three months of making your claim, your shares are deposited in another brokerage house.  In the worst case scenario, you could be waiting many months to get your shares back as your claim winds its way through bureaucratic hell.

 

Deflation

Deflation occurs when the inflation rate falls below 0%, which is kind of obvious when you think about it.  Whereas inflation represents an increasing cost of goods and services over time, deflation represents a decreasing cost of goods and services over time.  But isn’t decreasing costs a good thing?  Not necessarily.

Macro-economically speaking, in a mildly inflationary environment there is more money in circulation than goods and services, so individuals and firms increase production and create jobs in order to meet this demand and make more money.  Hyperinflation (compared to mild inflation) is a disaster, but that’s another subject.  In a deflationary environment, there are more goods and services out there than demand for them.  So, firms cut back, jobs get cut, and prices decline in response to the reduced demand.

All these declines in prices don’t just apply to stuff at the supermarket, they also apply to stocks and dividends.  As prices drop, firms bring in less revenue and stock prices decline as well.

As earnings decrease, dividends likely get cut back as well.  Deflation can easily become another nightmare scenario where you lose almost everything.

So how frequent and severe is deflation?  Deflation has been getting less frequent and less severe as time goes on as shown on the chart below (I swiped the chart from wikipedia).  Every time the blue line drops below 0% is a period of deflation.  The lower it drops, the more severe the deflation.

I would consider deflation the least likely of the three major risks outlined here, but it is still worth considering as you develop your investment portfolio.

That’s enough doom and gloom for now.  Tune in again, next week or so, when we’ll discuss dividend disaster prevention and recovery.

Disclosure: I am long BP and KO.

Readers:  Have you thought about investment disaster scenarios?  Are there any that I’ve missed?