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Summary

  • How income investors might view diversification a bit differently than growth investors.
  • What is the optimal amount of diversification for the income investor?
  • Why smaller portfolios reap the biggest marginal benefit from diversification.

A recent article on SA discussed a retirement portfolio consisting of only three income stocks. That's right, three stocks - American Capital Agency (NASDAQ:AGNC), Altria (NYSE:MO), and Prospect Capital (NASDAQ:PSEC). For disclosure sake, I'll note that I own both MO and PSEC, but this article won't be a critique about specific stock selection. It will be a discussion of diversification, a topic often glazed over by portfolio strategists, but seldom taken up in detail.

Why Diversification?

Diversification is commonly seen as a technique to smooth portfolio gyrations by the building up of assets possessing non-correlated attributes. Thus a portfolio of 25 energy companies, while better than a portfolio of three energy companies, would not be as diversified as a portfolio of 25 companies from 5 disparate industries.

So basically as more non-related assets are added to a portfolio, the less overall risk that is being taken by an investor. Heightened risk, as it pertains to growth investing, generally offers the potential for greater returns. As more growth stocks are added to a portfolio, the less influential any one security's performance becomes and risk is reduced. At some point, addition of too many growth stocks (overdiversification) may become counterproductive to benchmark-related capital growth goals. If one owns too many stocks, index-like returns may be the result, a self-defeating prospect for those predisposed to "beating the market."

Thus, a careful line must be drawn as how many securities to own to balance risk with reward.

The income investor will view things somewhat differently. With near-term capital growth and/or fluctuation somewhat of a subservient matter, emphasis is put on solidity and growth of the income stream. Viewed from this perspective, income investors want to own as many securities as necessary to lower the risk of income stream disruption. But as more securities are added to an income portfolio to protect the stream, the potential for cash flow growth may be stunted.

What Is The Optimal Amount Of Stocks To Own?

Simple math can help determine the amount of risk one is taking within a growth portfolio. If we put all our eggs in one basket, an entire portfolio hinges on the performance of one investment. As more securities with similar capital investments are added to the pot, individual security dependence is reduced as we see in the below chart.

# Of Portfolio SecuritiesPercent Weighting
1100
250
333
425
520
1010
205
254
303.33
402.5
502
1001

In real life, most investors won't have the same amount invested in all portfolio companies at the same time, with some positions taking on more weighting than others. Thus, weighting is determined by dividing each position by total portfolio capital. Still, as more securities are added to a portfolio, the overall weighting of each position declines, but so does the incremental benefit of doing so. If you own only three stocks, the marginal benefit of adding two more stocks far outweighs the benefit of adding two more stocks to a fifty position portfolio.

Many in the field of academia have taken up the question of optimal diversification. Evans and Archer in their classic 1968 study concluded that 10 stocks represented adequate diversification. This one, written about 20 years later by Santa Clara professor Dr. Meir Stratman, concluded that at least 30 stocks must be owned. Stratman states in this piece that:

Diversification should be increased as long as the marginal benefits exceed the marginal costs.

Of course with the advent of the Internet and electronic trading, costs have gone down substantially. And while things have changed with how folks invest today, general market risks wouldn't seem to be any different now than they were several decades ago. Stocks go up, stocks go down. Some companies have a consistent growth trajectory, while others go bankrupt. Some pay dividends, some don't.

Today, many market strategists opine that investors should have no more than 5% of one's portfolio in one stock, which would point towards at least 20 total positions.

So diversification advice from academics and market pundits is somewhat varied, but seems to fall in the range of 20-50 stocks. But what about if you are investing purely for income?

Since income investors are looking for stable and/or growing cash flow sources as opposed to sustainable capital growth, portfolio concentration may be more applicable to income being received from an investment as opposed to total capital being allocated to it.

For example, in the aforementioned portfolio composed only of AGNC, PSEC, and MO, with equal capital allocated to each, and rounding the yields of each to 11, 12, and 4.5%, respectively, we have the following:

StockYieldIncome Weighting
AGNC1140%
PSEC1244%
MO4.516%

So this portfolio is placing 84% of its income reliance on just two stocks with a blended yield of 11.5% - assuming equal capital allocation. For the retired investor needing a stable income, I'm not sure why anyone would want to limit themselves to such a small portfolio. As I've opined in the past, I would want to diversify as much as possible to diminish the effects that a possible dividend interruption, cut, or elimination would have on a portfolio.

While Altria is a company with a stellar dividend past, it operates in the litigious heavy tobacco industry. American Capital Agency just went through a volatile year in which it slashed its dividend, and Prospect Capital primarily lends money to small, private companies. Though this portfolio is diversified among three industries with arguably "best of breed" constituents, it is still exposed to a stock specific blowup, which minimally could lead to a dividend reduction.

Thus, the general risk to dividend interruption should be of prime concern to income investors. Companies that pay out most of their free cash to shareholders are basically always at risk of decreasing their dividends - American Capital Agency and Prospect being two examples of such.

Therefore, income investors should take Dr. Stratman's advice and continuing adding positions to portfolios as long as there is marginal benefit in doing so.

Marginal Benefit Analysis

What happens if we add just two positions to the three-stock portfolio? I selected two additional positions to diversify the current limited industry exposure, and keep the overall yield of the portfolio at 9 percent. I added ETV - Eaton Vance Buy-Write Opportunities - an option-income closed-end fund yielding nearly 9% and BBEP - Breitburn Energy Partners - an energy-related MLP yielding a bit over 9 percent.

StockYieldIncome Weight
AGNC11%24%
PSEC12%26%
MO4.5%10%
ETV9%20%
BBEP9%20%

Adding ETV and BBEP provides nominal as well as non-correlated industry diversification to the portfolio. If we had added Annaly (NYSE:NLY), another mREIT, and Apollo Investment (NASDAQ:AINV), another business development company to the portfolio, our diversification would not be as robust as when we include different business types.

If we add another 5 stocks designed to keep the portfolio at a blended 9% yield, the weight of AGNC and PSEC drops in half. From my perspective, adding another seven stocks to this portfolio would be of gigantic benefit. And if you want to take the fairly mainstream advice that advises no more than 5% positions in any one stock, another 10 after that might be prudent as well, but again, there is an incremental decrease in benefit.

At what point does the marginal benefit of adding more securities to an income portfolio begin to evaporate? As some of the academics have concluded, not all portfolios are created equal, and not all individuals have the same goals with their portfolios. Some are looking for 9% yield, which might constitute much more dividend interruption risk than someone who is looking for a 2-4% income stream with companies possessing lower payout ratios.

So for some, stopping at twenty income securities with 5% weight may be acceptable. Of course they must be willing to accept the risk of what happens if one portfolio position cuts, freezes, or eliminates its dividend and if a 5% income slice is digestible or not.

If that risk seems too high, then the marginal benefit of adding more securities is applicable. I would opine that 50- 2% positions, or even more might be appropriate for extremely cautious, conservative, or sensitive investors. Yet, with the thought that it will take another 50 positions to drop portfolio weightings another 1%, the marginal benefit of adding above 50 positions seems to outweigh the costs.

Even though today's nominal transaction costs might be acceptable to justify increasing the size of a portfolio, one must be able to periodically monitor the investments as well. There's little value in owning more securities if you become overwhelmed by the due diligence required to research and scrutinize your positions on an ongoing basis.

Conclusion

Though diversification is a worthwhile method of controlling cash flow risk, it is certainly not foolproof during "systematic" market upheaval. There is a plethora of opinion, both current and historical, on how many securities constitutes a sound range of assets.

My personal conclusion is that most income investors with adequate portfolio devotion time should own between 33-50 securities (2%-3% income weightings) for optimal performance. Additionally, the most diversified of portfolios will own a non-correlated mix of sectors and market capitalizations. Anything in excess of 50, while still creating benefit, may ultimately be more trouble than it's worth for the average retail investor.

Source: A Diversification Dissertation For Income Investors

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.