How Blue-Chip Dividend Investors Can Diversify Into More Wealth

| About: Vanguard Small (VB)

One of the pleasant dilemmas facing blue-chip dividend investors is that it is difficult to "diversify" a portfolio away from dividend growth stocks without diworsifying the portfolio. I mean, Procter & Gamble (NYSE:PG) has grown earnings by 9.0% annually for the past decade, IBM (NYSE:IBM) has grown earnings by 12.0% annually for the past ten years, ExxonMobil (NYSE:XOM) has grown earnings by 12.5% for the decade, and so on it goes across the universe of dividend bluebloods. When you own cash-producing assets that are growing earnings and dividends at a rate that is handily in excess of inflation, you probably do not feel a lot of pressure to "shake things up", particularly when most alternatives to owning blue-chip stocks don't seem to offer a high likelihood of improving the portfolio.

Sure, you could add some US bonds to your portfolio right now, but a ten year treasury bond only yields 1.73% right now. But Coca-Cola (NYSE:KO) yields 2.66% and comes with a half-century record of raising the payout. You could up the ante and get a thirty-year treasury bond, but that only yields 2.89%. Well, what do you know, Johnson & Johnson (NYSE:JNJ) also offers 2.89% right now, but while the treasury bond investor is stuck collecting his 2.89%, the Johnson & Johnson investor can rely upon the continuation of a fifty year dividend growth record that has taken care of shareholders by giving them 11.5% pay raises for the past half century.

Of course, you can buy something like gold, but that usually only beats productive assets during periods of extreme fear and paranoia and/or during periods of transition from low/moderate inflation to high inflation (in the latter half of the 20th century, Dow Jones stocks tend to lag for a couple years during periods of high inflation, while gold has a record of accelerating in price during this transition period). The problem with owning gold is that it has a miserable 70+ year record compared to stocks, and we still cannot escape the fact that it is non-productive. It cannot grow. It can never generate dividends, interests, or rent. It's just an ounce of gold. Your only bet is to find someone else to pay a higher amount for it.

But there is one form of diversification in particular that seems to come with its own set of benefits: small-cap index investing.

Ibottson & Associates puts out an annual handbook of collected data that tells you the historical performance of different asset classes over time. If you look at this chart from 1926 to 2010, you can see that a basket of small cap stocks is the place to be. If you invested $1 into large-cap stocks on January 1st, 1926, you would have turned that $1 into $2,982 in 2010. If you invested $1 into small-cap stocks on January 1st, 2010, you would have turned that $1 into $16,055 in 2010. Small cap stocks outperformed large-cap stocks by about 5x since 1926. That's a pretty important statistic to keep in mind.

The best way (that I am aware of) to capture these small-cap stock returns is to buy the Vanguard Small-Cap ETF (NYSEARCA:VB). The expense ratio is only 0.10%, and per Vanguard's website, the ETF "seeks to track the performance of the CRSP US Small Cap Index, which measures the investment return of small-capitalization stocks." I'm not much of an ETF guy, but owning a small-cap index such as the Vanguard Small-Cap ETF could meet the needs of an investor that wants to participate in the historically impressive returns of small-cap American indices without putting in the time and effort necessary to become an expert at small-cap stock picking.

Of course, there is no guarantee that purchasing a small-cap index fund will actually improve your performance. The Ibottson data merely reports the total returns of all large-cap stocks, but certainly does not make any allowances for (1) your ability to select excellent companies with high earnings growth potential, or (2) your ability to determine value prices at which to make purchases. But still, a small-cap index may be worth considering. Their staggering record of outperformance (as an asset class) from 1926-2010 could be persuasive data to start a conversation about whether there is room for 5-15% of your portfolio to be dedicated to small-cap indexing.

Most forms of diversification for blue-chip dividend investors reeks of "diworsification." It's hard to beat the best-in-class blue chip stocks. Small cap American indices are one of the few places where blue-chip dividend investors can diversify to actually improve their performance and, based on long-running historical precedents, actually create even more wealth.

Disclosure: I am long IBM, XOM, PG, JNJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.