U.S. Markets closed

Dividend Investing: Why Diversify?

As Mark Lowe noted in the first paragraph of his book "Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks", diversification is a proven strategy for managing risks posed by dividend stocks.

More broadly speaking, he wrote, "The fundamental concept behind this investment strategy is the theory that diversifying stocks in a portfolio can reduce the risk and can yield higher profits in the long run." Lowe followed up by noting that diversifying a portfolio can mitigate "unsystematic" or "residual" risk because stocks performing well can make up for the poor performance of other stocks.


By unsystematic or residual, he meant the kind of risk that exists within any industry or business. For example, there is always a possibility a competitor can develop new products or services that could take market share from a company in which you have invested.

One caveat: any discussion about the number of stocks needed for diversification must include the differences among them. Having a couple of dozen stocks in one industry is meaningless diversification, whereas having those stocks come from very different industries or sectors would be meaningful. Ideally, one set of stocks goes up in value as another goes down in the short term, while in the long term, the total portfolio value grows.

Investors just getting started or with small capital holdings will find it hard to diversify sufficiently, but can work around that by putting their money into mutual funds or exchange-traded funds.

More on residual risk: this type is unavoidable because every company, no matter how profitable and no matter how well managed, may be affected by unexpected developments. Just a couple of decades ago, retail was a great industry in which to invest--and then it was disrupted by online commerce.

This unsystematic risk involves the unknowns of the future, of what might happen to change companies or our expectations for them. Lowe offered the example of companies that serve retirees, a seemingly stable universe. Yet, new government regulations in the area of retirement policy could hurt or enhance the sectors involved with this demographic group.

To cite a positive example, he pointed out a downturn in the American economy might not affect Japan, making diversification with foreign stocks a good idea.

Turning to the importance of diversification, although some industries or sectors seem to promise above-average returns, avoid allocating too much of your portfolio to them. An obvious example was the rush into internet stocks in the second half of the 1990s, a rush that later turned into a very unhappy stampede to the exits. More recently, we've seen the cases of Enron and Lehman Brothers. Had you invested heavily in them, you might still be trying to get back to even.

If you are well diversified, some of your stocks will struggle at certain times, but other sectors might be thriving. For example, when energy prices take a downturn, investors who also own airline or trucking stocks may be on solid ground.

Lowe also advised against diversifying in the sense of investing in one sector for capital gains while investing in another to collect dividends. He wrote, "Your portfolio should be capable of sustaining unforeseen events because it is diversified."

He added that building a diversified portfolio begins with an understanding of the fundamental risk factors. Even with diversification, there are important risk factors to watch: the number of different stock holdings; financial leverage of each stock; dynamics between the holdings and the market cap.

According to Lowe, "The primary point of building your investment portfolio is to distribute the factor bets that are beyond your control, and focus your returns on the performance of each company."

Any discussion of diversification must inevitably lead to the question of how many different stocks are needed. Or, to put it another way, how concentrated or diversified should you be? The author pointed out the majority of investment companies, including Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), run concentrated portfolios. Most individual investors will not have the same knowledge and resources, however, so they should stick with more diversified portfolios.

After referencing several studies, Lowe wrote the ideal size of a portfolio would be 30 to 100 stocks; he followed up by noting several qualifications: the size of an investor's portfolio, resources for due diligence and trading costs.

An investor with $1 million obviously has the resources to buy and monitor several dozen stocks, while an investor with $10,000 probably shouldn't own more than a few stocks (broker fees can be prohibitive on smaller amounts). Yet, the small investor is not left out in the cold; diversified mutual funds and ETFs that pay dividends are readily available.

Resources for due diligence include the time needed to stay abreast of all official and unofficial reporting. Official reporting would mean reading quarterly and annual reports, as well as the financial statements attached to them. Unofficial reporting includes news stories and opinion pieces in the media.

Trading costs are the third qualification and important because even small bites out of an investor's initial capital can have a material effect in the long term. One of Buffett and Charlie Munger (Trades, Portfolio)'s secrets to success is to buy and hold, avoiding transaction fees (and taxes).

Finally, and to reiterate a point made in passing above, sectoral diversification is critically important. Lowe warned that some investors end up with too many stocks from one sector because they use specific investing rules, rules such as buying only stocks with price-earnings ratios below a certain level, or specific types of stocks such as green tech companies or consumer staples.

Stocks in the same sector are often sensitive to the same factors and, as a result, share the same residual risks. Lowe added, "Sadly, there's no fail-proof method that you can use to figure out which sectors would perform well in a specific period of time. Hence, it is important to diversify into the sector and industry levels."

Within that broad recommendation, there are a couple of qualifications. Do not invest in a sector that is beyond your expertise; if you feel you have some expertise but not a lot, consult with colleagues who do. He also reported that many dividend investors are cautious about tech companies because of the rapid rate of change.

Conclusion

In chapter eight of "Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks," we learned about the importance and benefits of diversifying our equity holdings.

Diversification helps us avoid residual, or unsystematic, risks because one set of stocks can carry the load while another is in decline. Stocks that pay dividends are subject to market volatility, so avoid putting too much capital into one stock or sector. Instead, invest across sectors and countries. And we should try to invest in sectors with which we are familiar and have some knowledge.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

Read more here:



Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.