Category Archives: Diversification
Diversification in a dividend portfolio � Intelligent Speculator
Regular readers know that I am a big believer in bothpassive dividend income funds and ETF retirement portfolios. Both have their advantages and I personally think when possible, having both is an advantage. They both have their positive and negative aspects but I would say that one concern that is much more important for a dividend portfolio is the need for diversification. While an ETF portfolio is the equivalent of owning hundreds of shares, with dividend portfolios, you are owning single names and become a lot more vulnerable if your portfolio is not diversified. Many examples come to mind but I think it’s fair to say that in recent years, investors that did not have proper diversification sometimes experienced massive pain. Just think about those who owned a dividend portfolio composed of banks, brokers and insurance companies a few years ago. No need to tell you they suffered greatly.
Why diversify ? (market events, laws, etc)
Since the objective of building this dividend portfolio is to create a long term source of passive income, it iscritical to not be too affected by any events. There are many different events that I need to be protected against. The example of owning financial stocks is perhaps the most obvious example of dangers in being too concentrated. Financial firms suffered from a major change of circumstances that caused not only a stock decline but also those companies were forced to diminish their dividend payouts.
If such changes affect only a portion of the portfolio, the long term impact becomes very limited. But if the entire portfolio suffers from such a change, it can greatly change the expected passive income. There are really no reasons to not diversify. You can find high yielding companies and companies that display constant growth in their payouts in so many different industries that I cannot think of a good excuse to not diversify.
How do you diversify? I did some research and did not find much information about diversifying a dividend portfolio, which is why I decided to write this. I think that even with 20, 30 or 40 stocks, it is very possible to get diversification. I will write more about an ideal number of shares later on but I would say that no matter how many different stocks you own in a dividend portfolio, the objective when adding a stock is to find a good dividend stock but also one that provides additional diversification to your portfolio. I’ve listed a few of the ways a portfolio should be diversified.
This is probably the easiest one to understand. Obviously, different sectors of the economy react very differently depending on the economic cycle. Being too concentrated in staples, technology, energy or any other sector will mean that you will outperform in specific circumstances and under perform in others. However, overall, your portfolio will have more risk associated with it than other more diversified portfolios with the same expected return. Ideally you would find dividend stocks in each of these sectors:
Security type diversification
Different capital structures offer different advantages and some such as trust units (especially Canadian companies), limited partnerships, preferred shares have various characteristics. For example, stocks, trust units and preferred stocks will react differently when the economy changes. Not only that but law and regulation changes can affect these securities differently.
I think it’s safe to say that laws that regulate stocks will not change too much but this warning is especially valid for investors who load up on specific types of securities. For example, many Canadian income trusts offered very high yields for a few years and attracted funds from around the world. However, the Canadian government modified its fiscal laws which resulted in major drops in those titles.Never become too concentrated or too vulnerable.
This one is kind of obvious. When selecting individual stocks, you should be careful to select stocks that are not too correlated between them. Many stocks could have relationships even though they are in different sectors. For example, while Family Dollar stores and Walmart are technically in different sectors, you can imagine that both companies do very well when the economy is doing poorly with consumers trying to save as much as possible on their purchases. In fact, Walmart probably has strong correlations but many of its suppliers which would include large companies in various sectors.
Even more obvious is the fact that within one sector, some companies have very strong correlation while others offer more diversification. You would always want to add a stock that will react well in different circumstances from the rest of your portfolio. It’s simply a warning to be careful about this.
Not a surprise but there are major advantages to diversifying the market. You do not necessarily need to buy stocks on foreign exchanges. In fact, simply buying multinationals or foreign companies listed on US exchanges is a good way to achieve that goal. What you want to avoid is having your portfolio greatly affected by a struggling country. If the US economy goes through a depression, it would affect companies around the world but the effect would be much much greater on companies that operate exclusively in the US. A company like Coca-Cola is so diversified that even a crisis in the US or in Europe would have a much smaller impact than a company like Wal-Mart!
So what are your thoughts on diversification in a dividend portfolio? Are you doing so in yours?