DGI Lesson 16: Diversification

In investing, one often hears that they should be “properly diversified.” What does that mean?

Diversification is a simple concept. At its most basic level, it means not keeping all of your eggs in one basket. The reason is obvious: If you have all of your eggs in one basket, and the basket falls, you will lose all of your eggs.

Thus, being undiversified is risky: A very bad outcome can result from just a single bad event.

[ad#Google Adsense 336×280-IA]Most investors want to avoid that kind of risk, and therefore they diversify their holdings.

Instead of putting all of their money into a single security, they spread their money into multiple securities.

That insures that if one investment flops, they won’t lose everything.

So diversification is a risk coping mechanism under which you mix a variety of investments into a portfolio.

The portfolio of diverse investments has a lower risk profile than if it contained just a couple of investments.

Diversification can help to smooth out performance. The positive performance of some investments will neutralize the negative performance of others. The performance of a diversified portfolio will always be better than the performance of its worst stock and less than the performance of its best stock. Diversification narrows the range of possible outcomes.

Diversification, while a pretty simple concept, has some special nuances for the dividend growth investor. Let’s explore them.

What is “risk”?

The answer may seem obvious at first. Risk = losing money, right? Well yes, the possibility of losing money is certainly a risk. But for the dividend growth investor, that is too narrow a definition. Let’s expand it for our own purposes.

The most common definition of investment risk is price volatility: How much do the prices of your investments vary – day to day, month to month, or year to year? When you read that an investment is “risky,” this is almost always what is meant: Its price is volatile.

The reason that this view of risk is so common is that if you have a highly volatile security, there will be lots of times when the price of that security is down. During those periods of time, you have an accounting loss.

If you were forced to sell at that moment, you would turn the accounting loss into an actual loss. Your risk would have been realized.

While this risk may be important to guard against, dividend growth investors find this definition too narrow. I agree with them, because (1) it only refers to price variations, (2) people are not often forced to sell when prices are down, and (3) if your main concern is income, temporary variations in price are not much concern to you.

Therefore, I use a more sensible definition of risk. My broader definition of risk includes things that threaten income and income growth.

So in dividend growth investing, things like this fit the broader concept of risk:

  • an investment’s return will be less than expected
  • some or all of the original investment will be lost
  • the dividend gets cut or suspended
  • the annual increase in the dividend is less than expected

Risk to Income
The basic goal for most dividend growth investors is to optimize their income.

Let’s say that you plan to retire in 10 years. You estimate that you will need $45,000 per year to cover your normal expenses: food, shelter, gas, travel, hobbies, medicine…everything that comprises your life and lifestyle.

Your estimate may become more refined each year as you get closer to actual retirement. But currently it is your best projection, and so you use it for planning purposes.

From the Social Security statements that you receive, you believe that you will receive $22,000 per year when you begin receiving SS, and your spouse will receive $11,000. So SS will cover $33,000 of the $45,000 that you think you will need.

That means that your investments will need to generate $12,000 per year to fill the gap between your fixed sources of income and what you think you will need. You would like to have more income, of course, but you really do not want to have less.

Plus, you know that each year, inflation will erode the purchasing power of your income. Social Security is indexed to inflation, so you want to be sure that the gap-filler income also grows at least as fast as inflation too.

As a dividend growth investor, you plan to fill the gap with income from stocks that you own. Therefore, you are more concerned about risk to the dividends, and to your portfolio’s dividend growth, than you are concerned about price fluctuations.

That is why you cannot limit your definition of “risk” to loss of principle. That would be very misleading. It is a fact that dividend income can go up even when stock prices are falling.

Consider this chart of a common dividend growth stock, Johnson and Johnson (JNJ), a company that I featured as the Dividend Growth Stock of the Month for June, 2015.

CaptureThe orange line represents JNJ’s dividend, and the blue line shows its price. You can see that over the past 10 years, JNJ’s dividend has gone up like clockwork every year. (In fact, JNJ’s dividend has gone up without fail for 53 straight years.)

Those annual dividend increases have occurred when JNJ’s price has gone up (as in 2013), down (as in 2015), or sideways (as in 2005-2007).

Dividends are independent of price. So if the most important thing to you is filling the gap to complete your retirement income, you can see why the risk that you are most concerned about is not risk to price. Rather, it is risk to your portfolio’s income.

How Does Diversification Help?
Diversification helps by spreading single-stock risk among many stocks.
Risk is based on probabilities. You want to estimate the probabilities of bad things happening plus the magnitude of damage if they happen.

Say that you have decided that, in your dividend growth portfolio, there is a 3% chance each year that one of your stocks will cut or suspend its dividend. That’s just a guess, but it’s an educated guess.

What you don’t know (and cannot know) is which stocks will cut their dividends nor when they will do it.

Let’s run some simple numbers. Your estimate of 3% chance that a single stock will cut its dividend in any year leads directly to planning that over 10 years, 30% of them will cut their dividend.

But you don’t know which ones will cut nor when they will do it. In a 30-stock portfolio, your 3% educated guess would mean that over 10 years, you expect that 9 of the 30 stocks will cut their dividends. In all likelihood, the events will happen unevenly:

Year 1: No cuts
Year 2: No cuts
Year 3: 2 cuts
Year 4: No cuts

And so on. After 10 years, there have been 9 cuts, but they occur unevenly. Until they happen, you don’t know which companies will be the culprits.

Diversification helps by making those unknowns less important, almost to the point that you don’t care. You have created a diversified portfolio of 30 stocks. If each one contributes equal income, then each of your 30 stocks is responsible for a little over 3% of your total income.

In a year when there are no dividend cuts, there is no effect on your income. But even in a bad year when there are, say, 2 cuts, only 6% of your income is affected. You can easily work around a 6% cut to your income.

In fact, you probably do not suffer a 6% income cut at all, even if those 2 companies eliminate their dividend entirely. That is because the other 28 stocks raise their dividends that year.

Say the average increase for the other 28 stocks is a modest 5%. If your income the year before was $12,000 (the gap-filler amount), your income the next year (trust my math) would be $11,760.

You can live with that result. Besides, as part of normal portfolio management, you will replace the 2 stocks that eliminated their dividends with 2 others that pay something.

How Do You Diversify?
I want my portfolios to be “well rounded.” That means that I try to diversify along multiple dimensions. I want a variety of income streams that are different from each other, so that it is less likely that more than one will suffer a negative outcome at any one time.

I will use the holdings in my Dividend Growth Portfolio (DGP) as examples of diversification across multiple dimensions.

  • Diversify among economic sectors, because different sectors have their up years and down years. There is a standard classification system called GICS, which stands for Global Industry Classification Standards. Here are their 10 economic sectors, with examples from my portfolio:
    • Energy – My DGP contains Chevron (CVX) and Kinder Morgan (KMI)… the Dividend Growth Stock of the Month for September, 2015
    • Materials – The DGP holds BHP Billiton (BBL)
    • Industrials – I hold no industrial stocks at this time. An example of an industrial stock would be General Electric (GE)
    • Consumer discretionary – My DGP has Hasbro (HAS)
    • Consumer staples – I hold several consumer staples: Coca-Cola (KO), McDonald’s (MCD), PepsiCo (PEP), Phillip Morris (PM), and Procter & Gamble (PG)
    • Health Care – I hold Johnson & Johnson (JNJ)
    • Financials – I hold several Real Estate Investment Trusts (REITs), which are considered financials: Digital Realty Trust (DLR), HCP (HCP), Omega Healthcare Investors (OHI), Realty Income (O), and Ventas (VTR)
    • Information Technology – My DGP has Microsoft (MSFT)
    • Telecommunications Services – Examples from the DGP: AT&T (T) and Shaw Communications (SJR)
    • Utilities – I hold Alliant Energy (LNT)

In 2016, a new sector will take effect, called Real Estate, which will cover many REITs that had formerly been categorized as Financials. So after the change takes place, I woll hold 5 companies in the Real Estate sector and none in the newly defined Financial sector.

As you can see, even in a 19-stock portfolio, I am able to have a pretty good degree of diversification across different economic sectors.

  • Diversify across industries and sub-industries, because they have their up and down years too. A single economic sector may have many industries in it. There are 156 sub-industries in the GICS system. For a list, see this document. In my Consumer Staples stocks, you can see how different industries are represented in the one sector: My 5 companies are in beverages, snack foods, fast foods, cigarettes, and household goods.
  • Diversify yields. While I have a minimum yield when I buy a stock (2.7%), I like to mix things up with a few higher-yielding stocks. Across my whole portfolio, the average yield is around 4%. So I have some 5%-6% yielders (such as AT&T) mixed in with my 3%-ers (such as Coca-Cola).
  • Diversify dividend growth rates. Often (but not always), lower-yielding stocks have higher dividend growth rates and vice versa. So my portfolio has room both for a stock like AT&T, with a high yield but only a 2% per year growth rate, as well as Microsoft that has just a 2.9% yield but a whopping 17% per year growth rate over the past 5 years.
  • Diversify size of company. While many of the best dividend growth stocks are huge “blue chip” companies, not all of them are. From my own portfolio, for example, both Hasbro and Alliant Energy are mid-size companies.

That completes the basic discussion about diversification. As I said, it is not that hard a subject.

Before we close, I want to add a few words about asset allocation and portfolio price volatility.

A Word about Asset Allocation
In Modern Portfolio Theory (see this article for an explanation and history), diversification includes the idea of investing in different asset classes. The 3 main asset classes are stocks, bonds, and cash. There are innumerable sub-classes, such as large-cap U.S. stocks, mid-cap growth stocks, or near cash (such as certificates of deposit).

Obviously, a dividend growth portfolio is made up only of stocks. Therefore it is inherently undiversified in the sense that other asset classes are omitted.

When I write about dividend growth investing, I never mean to imply that all of one’s investments should be in stocks or in dividend growth stocks. Every investor must decide for himself or herself how to allocate assets across different asset classes and sub-classes.

My articles about dividend growth investing relate solely to the equity portion of your portfolio. The focus is on how to construct a stock portfolio that is designed to meet specific goals, has acceptable risk and reward characteristics, and makes sense to you.

Even though all the assets in a dividend growth portfolio are in the single asset class stocks, we saw above how you can mitigate risk to your dividend stream by diversifying among a variety of economic sectors, industries, companies with different dividend characteristics, and the like.

A Word about Price Volatility
Earlier, I explained why the common definition of risk, which is restricted to the variation in an asset’s price, is too narrow. A dividend growth investor needs to expand it out to include risks to the dividend stream.

Nevertheless, portfolio volatility is important. Even the most income-centric investor may become unnerved if his or her portfolio drops 20% or 30% in a bear market – even if the income from the portfolio continues to grow.

Therefore, many dividend growth investors are at least a little interested in the beta of their portfolio. Beta is a measure of volatility compared to the market.

If “the market” is defined as the S&P 500, then by definition the S&P 500 has a beta of 1.0. An asset whose price tends to move less than the S&P 500 has a beta < 1.0, while a portfolio with more volatility has a beta > 1.0.

My own dividend growth portfolio has a beta of about 0.7-0.8, meaning its moves up and down tend to be about 70% to 80% of the market’s moves.

You can compute the beta of your portfolio by taking the average of the betas of the stocks in it. If every stock is equal weighted in the portfolio, then the beta of the whole portfolio is the simple average of betas. If the stocks have different weights, to get a precise result you would weight the beta of each stock before calculating the average.

I use beta as a minor factor in my write-ups of Dividend Growth Stocks of the Month. I consider a low beta to be a “plus factor,” because stocks with lower volatility are less likely to cause emotional reactions when the market is volatile. That helps you stick with your plan.

Bottom Line
Diversify your portfolio in ways that make sense to you. Buy stocks that differ in:

  • Economic sectors and industries within sectors
  • Size
  • Yield
  • Dividend growth rate

Shoot for a well-rounded portfolio that supplies you with multiple income streams.

Dave Van Knapp