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This is Part 3 of a 5-part series that highlights each step of our recommended investment plan that will help you build and monitor your own DIY Dividend Portfolio.

The Importance of a Proper Investment Plan

Most "do-it-yourself" investors fail miserably over the long-term. As a matter of fact, the majority of professional investors fail to beat the returns of the broader market indices every year. That said, there is one common trait that every successful investor shares…an investment plan!

Unfortunately, simply setting up an investment plan isn't enough to succeed these days. You also have to have the discipline to carry out that plan (come rain or shine). Contrary to popular belief, the market does not control your investment success…you do!

While the specific details of a dividend investor's personal investment plan will vary based age, risk tolerance, etc., we suggest that investors use the plan below as a guide (links to previous parts of this series are highlighted below in blue):

  1. Identify, research, and invest in dividend stocks with the best risk/reward profiles.
  2. Identify low-risk entry points for each stock (i.e., a "Buy Zone").
  3. Adhere to strict asset allocation targets (for asset classes, industries, and individual stocks).
  4. Maintain a disciplined exit strategy for each stock by closely monitoring changes fundamental and technical data points.
  5. Utilize portfolio hedging techniques and conservative option strategies to manage downside risk.

Part 3: Asset Allocation Strategy

"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 5 of this series.

Why Diversify?

Dr. Van K. Tharp, a renowned 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 JPMorgan (JPM) and Bank of America (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 "High Yield" Exposure (20-30% of total portfolio) - Generally speaking, high-yield stocks (i.e., stocks with yields greater than 6.0%) are either speculative in nature or they have different tax circumstances (e.g., master limited partnerships ("MLPs") and real estate investment trusts ("REITs")). Some of these stocks may have company-specific issues that warrant a higher yield or they may operate in a high-risk, volatile industry. While high-yield, speculative stocks are not appropriate for every investor; many of these stocks have strong risk/reward profiles (particularly MLPs and REITs) and can offer good risk-adjusted returns for a diligent investor. That said, we recommend that investors limit their total exposure to "high yield" stocks.
  • 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.

Summary

We believe that these 4 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 (AAPL), which has a scary cult-like following, high-yielding stocks like Annaly Capital Management (NLY) and American Capital Agency (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 highlighted our rules for finding low-risk entry points in Part 2 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.

Source: Building A DIY Dividend Portfolio (Part 3): Asset Allocation Rules