Diversification

I’ve never discussed diversification on this blog before, at least not to a major degree. I did allude to it in my recent post updating my portfolio. I’m not here to preach or educate anyone, I’m here to share ideas and learn from other investors. I really believe that the level of diversification an individual investor needs varies based on objectives, time horizon, risk profile and what you’re comfortable investing in.

First off, let’s define diversification. According to Investopedia, diversification is defined as follows:

A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.

So, this defines diversification to a basic degree. You can diversify between companies, sectors and countries in order to limit risk and stem losses in a market slide. It’s a fine line to walk, however, as you can over-diversify to the point of limiting gains.

 My personal thoughts on diversification revolves around owning two or three very strong companies in as many sectors as I can afford and find attractive. In oil I like Exxon Mobil and Chevron. I own both, and just so happen to own Total for a little foreign exposure. I think Sysco is the best foodservice distributor in America. I own a piece of that business, and feel good about it, even in the face of declining profits with higher input costs. You can see where I’m going here. Take a sector and when you start narrowing it down to who is on dividend champion/achiever lists, who is profitable, who has an economic moat and who is the leader in that particular sector you start to see a very small list. Those companies are where my attention, and therefore my money, usually end up.

How many companies should you own? There is no right answer. A lot of it will revolve around how much money with which you invest. I typically invest $1,000-$1,400 a month and usually just purchase stock in one company with that amount. If I try to split that into two transactions broker fees typically eat into potential future profits.

In my opinion, the best way to figure how much diversification is necessary is to try and weight your holdings so that no one company has more than a 15% weight in your portfolio. In my particular portfolio, the Freedom Fund, Johnson and Johnson makes up 14.4% of my total investments. That is pretty close to as high as I’d like any one company to be and will probably shy away from buying any more right now. I’d be ok with temporarily going over 15% with one company if I felt it was of particular value. There are no hard rules with investing. You have to find your own comfort zone and go with it.

Although I feel there is no right amount of diversification, I do believe one can diversify too much and enter the “diworsification” territory that Peter Lynch famously coined. This is when you diversify to the point of maximizing safety and mitigate any potential gains. If your goal is to “buy the market” you are probably best served buying index funds instead of trying to buy so many companies that your potential gains are probably minimized.

In the end, only you can answer the diversification dilemma for yourself. I think if you base it on how much money you have to invest with and try to weight your investments appropriately you will arrive at a level of diversification that is customized to your individual approach.

When I’m all done with buying investments and I reach the point where I’m living on my dividends, I plan on owning 25-30 companies in 7-8 different sectors. I think that’s an appropriate amount of diversification to minimize risk and maximize gains.

What’s your level of diversification?

Thanks for reading.

Comments

  1. says

    Hi Dividend Mantra,

    Good post man! When I think of “diversification” I always assume that means diversifying across asset classes i.e. stocks, bonds, cash etc. I’m not sure I could do the 100% stock thing and ride that kind of market volatility! To me even if you diversify your stocks across sectors, you are still not diversified.

    Have you considered short-term bond funds or ETFs? (1-5 year laddered). They have a higher yield than dividend paying stocks, and are “inversely correlated” to the stock market. The returns on these are pretty good, and will give you a good cushion when markets get hit with a downturn. Interest rates aren’t going to surge in any big hurry.

    Regardless I like your investing approach and I think you will do well :)

  2. says

    Dividend Ninja,

    Thanks for stopping by.

    I suppose my age has something to do with the fact that I am 100% equities. I suppose the low interest environment also has something to do with the fact that I’m shying away from bonds and fixed-income right now. When interest rates inevitably rise I may look into diversifying into other asset classes, but I’m extremely pro-equities. I always like to have 10% cash on hand, however.

    When speaking of market downturns that simply gives me an opportunity to buy more shares in the companies I’m so enthusiastically invested in. I’m actually looking forward to a hopeful 5% or more pullback this summer. Market downturns and loss in market value of my investments only matter on my net worth statement, which is fleeting at best. The passive income stream is what I look at.

    Hope you’re having a great weekend!

  3. says

    Thanks for leading me to this posting. What are the 7-8 sectors you are looking at?
    I have been thinking 40ish stocks, but I need to make sure I am not too heavy in once sector.

  4. says

    me myself and I,

    The sectors I’m looking at include healthcare, technology, telecommunications, utilities, consumer staples, conglomerates, energy, etc. I don’t think 40ish stocks is a bad idea and that may very well be where I end up. Thanks for stopping by!

  5. says

    Hi Dividend Mantra,

    First of all, thank you for this great blog! It is quite interesting to read you.

    I like the diversification you propose, I see it in a similar way. Perhaps, I try to diversify more between euro and dollar.
    In connection to the diversification I would like to carry out in USA companies, I would like to explain to you my situation and get some pieces of advice.

    I live in Germany and started creating my portfolio some months ago. As you know, Europe economy is not going through its best times, which leads to a undervalued market.
    Thus, I have performed most of my investment in European companies (e.g. Munich RE, Telefonica, …). Nevertheless, I have analyzed quite a lot USA blue chips and sooner or later would like to add a considerable number to my portfolio.
    To do so, I have put aside around 40,000 € waiting for a little less overvalued USA market.
    This amount represents around 50% of my initial investment, funds saved for some years when I didn’t know about this awesome investment strategy based dividend growth companies.
    Right now, it is quite difficult to find good USA companies with PER below 15, which is one of the criteria I started using to build my portfolio.
    Of course, there are exceptions since the index is just a reference of the overall situation. I have already positions in CVX, and consdirer that energy, insurance and banking industries are at good price at the moment.
    The point is that this fund was reserved mainly for certain defensive sectors which are not easy to find in Europe, e.g. KO, MCD, PG, JNJ, … Unfortunately, this fund is providing me with little profit at the moment (time deposit giving less than 1,4%).
    So, I started considering other options:
    1. Start investment in USA even if the companies are a little bit overvalued. Even Wal-Mart, which is one of the cheapest at the moment, trades at x14,21. In Europe, I am trying to invest in companies trading at P/E even lower than 11 (being P/E < x15, let’ say okish).
    2. Invest this fund in European values and rotate the portfolio, if possible, when the heated USA market gives a chance.
    3. Keep the money in the current time deposit getting low interest. Or even moving to another time deposit with higher interest, but with less liquidity. At the moment I can cancel it without penalization in quarterly windows.
    If the interest were higher, probably I would only have the money, without losing the interest, available in yearly basis.

    Sorry for the long paragraphs, I would appreciate whether you could share your view.

    Thank you in advance!!

    • says

      Hadamard Business,

      I’ve always invested capital as it’s become available right from the beginning. I don’t pay much attention to the broader market’s valuation and instead pick out companies I think are attractively valued based on all known fundamentals and growth prospects, while also considering portfolio weighting.

      If I were in your situation, with that much cash, I’d simply DCA (dollar cost average) my way into individual positions. I’d allocate a monthly amount I was comfortable with (say $5k or so) and then buy into the best possible opportunities I could.

      Try not to think about today. Try thinking about 20 years from now. Is WMT still going to be $73 per share in two decades? Will it matter if you paid $73 or $75 if it’s $200 per share? Valuation is important, but inaction is disastrous.

      Best of luck to you.

      Cheers!

  6. says

    Thank Dividend Mantra for your recommendation and prompt response, highly appreciated. Recently read an article from Seeking Alpha showing interesting results from DCA: http://seekingalpha.com/article/999321-dividend-growth-investing-dca-vs-timing-technique.
    I think that what you propose is a quite sensible approach and easy to implement. The only concern that I have is that by following such strategy, do you think that your portfolio may grow more than expected (in terms of number of companies)?
    What leads me to the next question, which is the target number of companies you expect to have in your portfolio? I see that recently you reported 39 companies, I wonder if this is not too many to keep control. I had in mind that around 20 companies (USA and Europe) would be a fair number, and by my retirement (I am 31) something around 30.
    Sorry for asking so many questions, but I am quite interesting in this approach and would like to have clear idea of collateral effects, as potential high number of companies.
    Just one comment, I participate in one forum in Spain, of course, focus on long-term investment. There, I see as people try to have a smaller number of companies in their portfolios, but when I deep into the dividend growth investment blogs in USA and Canada, I observe a much higher number of companies (something between 30 y 40). A curiosity.

    Cheers!

    • says

      Hadamard,

      I’m going to look to eventually own a stake in 50 companies or so. This is to diversify income across multiple holdings. This way, if one company eliminates the dividend and the weightings are somewhat even I’ll be looking at a 2% or so cut in dividend income. If I were to only own 20 companies and one company eliminated the dividend my income would be reduced by 5%. That’s a big difference. Although I’m quite confident in my holdings, there is no telling what the future will bring and I prefer to diversify my income as much as possible to reduce the chances of significant income loss in retirement.

      Best wishes.

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