DGI Lesson 16: Diversification

Introduction

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. For example, say you had all of your assets in a single stock, and that company suddenly fell apart, eventually going bankrupt. Your asset values would fall, eventually becoming worthless.

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 and/or multiple asset classes.

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

Diversification is a risk coping tactic by which you mix a variety of investments into a portfolio.

You do it to minimize the impact of any single security on the portfolio’s overall performance. The resulting risk reduction is often referred to as the only free lunch in finance.

Diversification can help to smooth out performance. As time goes on and prices go up and down, 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 thus narrows the range of possible outcomes.

Diversification has some special nuances for the dividend growth investor. Let’s explore them, beginning with an examination of risk itself.

Risk

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 so that it is more helpful.

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,” what is almost always meant is that its price is volatile.

This view of risk was established decades ago by the terminology used in academic papers. The reasoning behind it 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 (that is, it’s a loss on paper).

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. You would lose money.

While this risk may be important to guard against, most dividend growth investors find that the traditional definition of investment risk is 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 definition of risk includes not only the potential loss of money, but also 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
  • The overall dividend return falls short of what you need

Risk to Income

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

Let’s say that you’re 52 and 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 will 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 (SS) 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 retirement 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, preferably faster.

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. The dividends represent your gap-filler income. Prices do not.

That is why you cannot limit your definition of “risk” to potential 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 15-year 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, 2018.

The orange line represents JNJ’s dividend, and the blue line shows its price. I have circled 3 periods when JNJ’s price fell back by a considerable amount.

Despite those periods of negative price volatility, you can see that JNJ’s dividend went up like clockwork every year. (JNJ has increased its dividend for 56 straight years.) JNJ’s dividend did not go down even when its market price fell. The risk to JNJ’s dividend has been significantly different from – and smaller than – the risk to its price. In other words, its dividend has been far less volatile than its price, and all of the dividend’s volatility has been upward.

Dividends are independent of price. (See DGI Lesson 7: Dividends Are Independent from the Market.) 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. It’s the product of the probability of bad things happening times the magnitude of damage if they occur.

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 a 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 bad 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 3.3% of your total income.

In a year when there are no dividend cuts, there is no negative effect on your income. But even in a bad year when there are, say, 2 cuts, only 6-7% 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 same 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 eliminate 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.

Economic Sectors

There is a standard classification system called GICS, which stands for Global Industry Classification Standards.

Different sectors – and asset classes – have their up and down years. In the following table, each color represents a different economic sector. (White indicates the average, and gray indicates the S&P 500, which is diversified but not equal-weighted.) The table covers the past 10 years.

[Source]

The chart is filled with fascinating facts:

  • 6 different sectors led at least 1 year.
  • 5 different sectors were worst at least 1 year.
  • Equal-weighting all sectors invariably turned out around the middle; so did the S&P 500 in most years.
  • Individual sectors often went from best to worst or vice-versa. Examples: Utilities was worst in 2012-13, then vaulted up to best in 2014. Energy was worst in 2014-15, best in 2016, then worst again in 2017.

Here are the 11 economic sectors, with examples of stocks that I hold in my portfolio:

    • Communications Services – AT&T (T), Verizon (VZ)
    • Consumer discretionary – Hasbro (HAS), Lowe’s (LOW), McDonald’s (MCD)
    • Consumer staples – Altria (MO), Coca-Cola (KO), PepsiCo (PEP), Phillip Morris (PM), Procter & Gamble (PG)
    • Energy – Chevron (CVX)
    • Financials – None at this time
    • Health Care – Amgen (AMGN), Johnson & Johnson (JNJ)
    • Industrials – Boeing (BA)
    • Materials – None at this time
    • Real Estate – Digital Realty Trust (DLR), Realty Income (O), Ventas (VTR)
    • Technology – Cisco (CSCO), Microsoft (MSFT), Qualcomm (QCOM)
    • Utilities – Alliant Energy (LNT), Southern (SO)

As you can see, even in a relatively small 23-stock portfolio, I am able to have pretty good diversification across different economic sectors. Nine of the 11 sectors are represented.

Diversify across industries and sub-industries too, because they can have their ups and downs within a single sector.

In my Consumer Staples stocks, you can see how different industries are represented: My 5 companies cover the beverage, snack food, cigarette, and household goods industries.

Yields

I like to mix things up with low-yield, mid-yield, and high-yield stocks. Across my whole portfolio, the average yield is usually in the 3.5%-4% range, but the lowest might be below 2% (such as Lowe’s) while the highest may be 6% or more (AT&T).

Dividend Growth Rates

Often (but not always), lower-yielding stocks have higher dividend growth rates (DGR) and vice versa. So in addition to diversifying by yield, I diversify by DGR.

So my portfolio has room both for a stock like AT&T, with a high yield but only a 2% per year DGR, as well as Microsoft that has a sub-2% yield but a whopping 14% per year DGR over the past 5 years.

Size of Company

While many of the best dividend growth stocks are huge “blue chip” companies, not all of them are. In my own portfolio, for example, both Hasbro (Consumer Discretionary) and Alliant Energy (Utilities) are mid-size companies. REITs (Real Estate) are often smaller companies too.

How Many Stocks Should You Own?

Obviously, diversification implies that you own more than one stock. But how many is enough?

We know that the fewer stocks you own, the greater is your risk. You have more exposure to single-stock risk – the impact of bad things that might happen to an individual holding.

Say you hold X number of stocks in equal amounts. This table shows how much of your wealth/income is at risk from a bad thing happening to each individual stock, as a function of how many stocks you own.

Remember, the risk referred to in the second column includes risk to income, not just price. The table clearly implies that the lower your tolerance for risk, the more stocks you should hold.

That said, the table also shows that there are diminishing risk-reduction benefits from continually adding new stocks to a portfolio. The 50% risk reduction that you get from adding 1 stock to a 1-stock portfolio drops to 1% risk reduction from adding 5 stocks to a 20-stock portfolio. At some point, adding more stocks confers almost no statistical benefit and increases your work.

Ultimately, in my opinion, it becomes a matter of personal preference and comfort. When I began my Dividend Growth Portfolio, it had 10 stocks, and I allowed any of them to be worth up to 20% of the portfolio. (Obviously, I did not anticipate having an equal-weighted portfolio.)

In the 10 years since, I decided that was too risky for me. Therefore, I have changed my guidelines a couple of times. Currently, I am aiming for 20-30 stocks and a maximum position size of 10% of the portfolio. (To see the complete Business Plan for this portfolio, click here.)

My 10% allowable maximum position size would still be too risky for many investors. I think that 5% or 4% is more typical. If positions are equal-weight, that would imply portfolios of at least 20-25 stocks.

As we often see, there is a tension between the math and the psychology of investing. The bottom line is that you should design your dividend growth portfolio to meet your unique goals and tolerance for risk. There is no one-size-fits-all answer to the question of how many stocks to own.

Diversification is Not the Only Risk-Control Technique

Just as a reminder, diversification is not the only way that you can keep risk to a level that you find acceptable. Other techniques include:

Also, remember that your tolerance for risk will be favorably impacted by the degree that you understand your investments and construct a portfolio that specifically targets your unique goals. To read more about setting goals, designing strategies, and writing your own business plan, see Lessons 12 and 13.

A Word about Asset Allocation

This article is specifically aimed at the subject of diversification in a dividend-growth portfolio.

Diversification writ large is a much broader subject. Dividend growth stocks are only a niche selected from all of the possible investments that are available.

In Modern Portfolio Theory, 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 or municipal bonds.

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 capital and 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 – variation in an asset’s price – is too narrow. A dividend growth investor needs to expand the definition 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 price 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, meaning it moves up and down at about 70% as much as the market.

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.

Key Takeaways from this Lesson

  1. Diversification means owning multiple assets, as distinguished from putting all your eggs in just 1 or 2 baskets.
  2. Diversification is a risk-control technique. While you never have total control, and certainly can never eliminate risk when you invest in stocks, diversification holds risk down by spreading your bets among different stocks with different characteristics.
  3. Construct a portfolio with enough stocks to provide sufficient diversification, but not so many that it’s too much work to keep track of them. Both of those judgements are up to you. Many investors find that their sweet spot is in the 20-30 stock range.
  4. Diversify your portfolio in ways that make sense to you. Buy stocks that differ in:
  • Economic sectors and industries within sectors
  • Company size
  • Yield
  • Dividend growth rate
  1. Remember that dividend income can (and often does) go up even when stock prices are going down. That knowledge can help you stick with your investing plan even when others are panicking.

Dave Van Knapp