Last week we completed our 9-part series titled "Building A Do-It-Yourself Dividend Portfolio" in which we highlighted our top-rated dividend stocks within each sector. Our goal was to provide fellow DIY investors with a diversified pool of high-quality dividend stocks that we feel have the potential to be a core holding in your DIY Dividend Portfolio.
While the response to this series was extremely positive (and we thank all readers for their thoughtful feedback), we received many comments and questions asking us to provide additional details about the actual "plan" that governs the DIY Dividend Portfolio. To be completely honest, this was music to our ears. We believe that planning is the most important part of the investing process, yet most investors spend the least amount of time on it (if any time at all).
That said, today we begin a new 4-part series that will highlight our 4 key principles (in order of importance) to building a successful DIY Dividend Portfolio:
- Asset Allocation/Position Sizing (i.e., how much should you buy of each dividend stock?)
- Exit Strategy/Risk Management (i.e., when should you exit a stock or hedge your dividend portfolio?)
- Stock Selection (i.e., which dividend stocks should you choose for your portfolio?)
- Entry Strategy (i.e., when should you buy a specific dividend stock?)
Most investors fail to succeed because they either do not have a plan or they do not have the discipline to stick to their plan. Plain and simple. We passionately believe that if you make these 4 key principles the heart of your investment plan, you WILL achieve long-term success. In addition, we strongly encourage investors to physically write down their rules of investing. This will increase the odds that you will actually follow your rules, which ultimately will increase your odds of success.
Part 1: Asset Allocation/Position Sizing
"Diversification is the only free lunch" - Harry Markowitz (winner of the Nobel Prize for Economics)
When Mr. Markowitz wrote about diversification in 1952, he was one of the first people to link investment risk with return. While we think Modern Portfolio Theory has its flaws, we do believe that an investor can reduce overall portfolio risk by holding a combination of stocks that are not 100% positively correlated. However, it should be noted that diversification can only reduce "unsystematic risk" (i.e., company-specific risk), which is only half of the risk management battle. We will touch on ways to reduce "systematic risk" (i.e., market risk) through various hedging techniques in Part 3 of this series.
Dr. Van K. Tharp, a renown author and investing coach, originally coined the term "position sizing". Dr. Tharp adamantly believes that poor position sizing is the #1 reason why investors fail to succeed. In other words, investors often fail due to an abnormally large position going sideways, which ends up sending their portfolio into a downward spiral that is almost impossible to recover from.
Dividend growth investing has proven to have a significant amount of "edge" over the long-term. However, in order for investors to realize that "edge", they need to stay in the game long enough to win. We agree with Dr. Tharp that the best way to stay in the game is to manage your position sizes appropriately.
By diversifying your portfolio, you reduce the risk that one stock or industry derails your entire long-term investment plan. For example, if an investor was heavily-weighted in the financial sector during the 2008 credit crisis, he or she is still probably feeling the pain. Stocks like JP Morgan (NYSE:JPM) and Bank of America (NYSE:BAC) had an average dividend yield of 3%-4% for decades before the party ended abruptly. Not only did both companies cut their dividend completely, but the stocks (which had historically been relatively stable), were also down over 70% each (from peak-to-trough). This is a dividend investor's worst nightmare.
Simple Rules for The DIY Dividend Portfolio
We believe that investing rules should be as simple as possible. This is the only way to ensure that you will follow them consistently. That said, below are our simple Asset Allocation/Position Sizing rules for the DIY Dividend Portfolio:
- Maximum Stock Position (3-5% of total portfolio) - We believe that a diversified DIY Dividend Portfolio should include at least 20-30 high-quality dividend stocks, with no stock accounting for more than 5% of the total portfolio.
- Maximum Industry Position (15-20% of total portfolio) - Ideally, a DIY Dividend Portfolio should include stocks from a variety of industries. However, under no circumstances should one specific industry or sector account for over 20% of the total portfolio.
- Maximum Portfolio Beta (less than 0.75) - We believe that low beta dividend stocks offer investors the best long-term risk-adjusted yields. As such, we target a weighted-average beta of less than 0.75 for our DIY Dividend Portfolio. Generally speaking, low beta stocks tend to dampen overall portfolio volatility.
We believe that these 3 simple Asset Allocation/Position Sizing rules will drastically improve your odds of long-term success. We can't tell you how many investors we talk to that are overly exposed to one stock or industry. Other than Apple (NASDAQ:AAPL), which has a scary cult-like following, high-yielding stocks like Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) are probably the worst culprits right now. Investors tend to get enamored with these high-yielding mortgage REITs and throw all caution to the wind.
If you are a new dividend investor and are building your DIY Dividend Portfolio from scratch, don't feel pressured to have a fully diversified portfolio on day one. Dividend investing is a marathon, not a sprint. We will highlight our rules for finding low-risk entry points in Part 4 of this series. It's extremely important to be patient when building a long-term portfolio.
Note to readers: We will be continuing this very important series over the next few days, so please make sure to"follow" us.