Diversification matters because it protects investors from the proverbial bad apple that can take a serious bite out of your dividend income at the worst possible time. Dividend investors should construct an income producing portfolio consisting of at least 30 individual stocks, which are representative of as many sectors that make sense, in order to be somewhat diversified.
One of the main concerns that some investors have against diversification involves time spent keeping up with companies and the quality of new investments purchased.
The problem is that not every company is a quality one, and by expanding their list of holdings from 20 to 40, some investors are concerned that the quality of the portfolio would be deteriorating. This could be particularly true if investors were simply adding additional positions in companies for the sake of adding new positions simply to meet the number of positions requirement. Investors should never sacrifice quality of the companies they buy stock in simply for the purposes of diversification. Owning shares of a company that makes horse-carriages just so you have exposure to the sector would have been a bad idea ever since the automobile became mainstream in the early 20th century. Investors should choose only these quality stocks that make sense and which are attractively valued.
The number of positions in a portfolio will depend on the external environment and the availability of quality firms at attractive valuations. It is much easier to start a dividend portfolio when stocks are undervalued, than when stocks are hitting new all-time-highs every day. However, in my investing, I have found that there are usually at least 20 quality dividend companies with sustainable competitive advantages which I find attractively valued. I still monitor companies with solid competitive advantages that I have added to a wish list for a potential inclusion to my portfolio in order to be ready when the right time comes. For example, in early February, I bought shares in McCormick (NYSE:MKC) and Diageo (NYSE:DEO) on the dip, thus taking advantage of a brief sell-off that had temporarily taken those shares into value territory.
The initial amount of time spent to research new positions can easily consume 10-30 hours per week. However, keeping up with new material developments affecting the company should not take more than a few hours per week. This makes a diversified portfolio of 30-40 individual securities manageable to maintain and monitor.
There are ten major sectors as identified by Standard & Poor's. For my portfolio, I try to gain exposure to as many of these sectors as possible by purchasing the top three or four companies that pay rising dividends. This provides for an easy pool of at least 30-40 companies to own at some point in a diversified dividend portfolio, without lowering the quality of an income portfolio. By selecting the top three or four players in a given industry, when one incidentally ends up cutting dividends or going under, the other major players in the field will win business or might be available for purchasing on dips. As a result, the overall risk to the portfolio is not going to be that high, unless the whole sector is imploding. Of course, it doesn't make sense to merely add companies for the purposes of diversification. If a company is not perceived as a good quality by the investor, and it cannot be purchased for a good value today, then it should not be acquired, even if that means no exposure to the sector altogether. In some sectors such as energy, it is easier to select the top players since most companies in this group of stocks tend to pay a stable and rising dividend. In other sectors such as Technology, it is more difficult to find a company that has raised distributions for over 20 years in a row for example. The availability of good stock candidates for inclusion in a dividend portfolio is going to vary over time. For example, back in 2008-2009, I found utilities like Con Edison (NYSE:ED) or Dominion Resources (NYSE:D) to be decent picks. Currently, I am having a hard time justifying a purchase in any utility company in the US.
In my personal experience, having a diversified portfolio representative of many sectors and involving multiple companies per sector has definitely shielded me during difficult times.
For example, back in 2010, my energy holdings included Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX), BP (NYSE:BP), Kinder Morgan (NYSE:KMR) and Enbirdge Energy Management (NYSE:EEQ). When BP cut dividends in 2010, I immediately sold the stock. With the cash proceeds I purchased a stock which was in the energy sector and was also based outside of the US. The company I purchased was Royal Dutch (NYSE:RDS.A) (NYSE:RDS.B). I could have easily purchased any of the other major oil players, and had similar results. Whenever I sell a stock, I try to replace it with the stock of a company in the same industry when possible. However, this is not always a viable alternative.
Another example was during the 2008-2009 period, when many financials cut dividends. I ended up selling State Street (NYSE:STT), General Electric (NYSE:GE) and American Capital (NASDAQ:ACAS). However, other financials such as Aflac (NYSE:AFL) or M&T Bank (NYSE:MTB) did not cut dividends, which is why I hung on to them. I even ended up adding to Aflac at some crazy low prices. Unfortunately, the financial sector did not offer many financial companies that fit my models, which is why I ended up reinvesting most of the funds generated from the sales in stocks from other sectors.
To summarize, it is important for ordinary investors to spread their risk out in order to protect their nest egg. This could be easily done by creating a diversified dividend portfolio that includes at least 30-40 equally weighted positions that are built slowly over time and purchased at attractive valuations. One should not add companies merely for the sake of adding companies of course. However, based on my experience since 2007-2008, a decent number of quality dividend paying stocks is always available at attractive valuations to the enterprising dividend investor. Therefore, it is quite possible to build a diversified portfolio of quality companies and live off dividends, without being exposed too much to sector risk. As I frequently say, the goal of dividend growth investor is to get rich and stay rich. I believe that one needs to get rich just once in their lifetime, and then reap the rewards for the rest of their life.
Disclosure: The author is long XOM, CVX, EEQ, BP, AFL, MTB, KMR. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.