Dividend Investing: To Diversify Or Not To Diversify

Includes: AXP, GHC
by: The Part-time Investor

If it's your game, diversification doesn't make sense. It's crazy to put money into your 20th choice rather than your 1st choice. It's the 'LeBron James' analogy. If you have LeBron James on your team, don't take him out

-Warren Buffett

Diversification is something that stock brokers came up with to protect themselves, so they wouldn't get sued for making bad investment choices for clients - Jim Rogers

Wide diversification is only required when investors do not understand what they are doing.- -Warren Buffett

The way to get rich is to put your eggs in one basket, but watch that basket very carefully. And make sure you have the right basket. - Jim Rogers

Diversification is a hedge for ignorance.-William O'Neil

As I've been reading the articles on SA and as I've been developing my own investment plan and philosophy I have been struggling with the question of diversity. How important is diversity? What is too little diversity? What is too much? From the quotes above, it seems that some of the smartest investors in the world believe that holding a relatively few stocks works best. I certainly would never argue with Warren Buffet, and what he says concerning diversification makes sense. What Buffett has espoused is finding stocks that are undervalued, buying them, and holding them forever. He feels that it is actually fairly rare to find a stock that is really undervalued and worth investing in, so when you find one, invest heavily.

Two examples of this are his investments in American Express (NYSE:AXP) and The Washington Post (WPO). Both were bought for heavily discounted prices, compared to their inherent value, and both have multiplied many times over since he has owned them. But the purchase of these two stocks is actually a fairly rare event for him. Buffet usually holds positions in only about 30 stocks, and at times has had quite a large percentage of his portfolio in less then 10. This is because he is not interested in diluting his best ideas with lesser ones. If he feels he can identify a stock that will go up in price by 10 times over the next decade, why would he ruin that return with a stock that will only double? That's what he means when he says "it's crazy to put money into your 20th choice rather then your first." If your first choice is so good, put more money into it.

The problem with this rests on two issues. First, every investor has different abilities and every investor has different goals. Whether or not to diversify depends greatly on who you are as an investor. To be comfortable having such low diversity, you must be really good at picking stocks. Lets face it, there is only one Warren Buffet. And I don't have the intellect, experience, or expertise (or confidence) to be able to pick stocks like him. The other issue is that, even assuming you can pick stocks as well as Buffett, putting all your money into your few very best selections works best if you are looking for (and achieve) capital appreciation. As a dividend investor, I have a very different philosophy, and a different take on diversification.

I certainly don't mind if my stocks go up in price, and I assume that if I pick the right stocks, with good dividend growth, then capital appreciation will come. But it is not my focus. As an income investor, my goal is not just to develop a steady, growing income stream, but also to protect it. Since my strength is not necessarily picking stocks, I may (and probably will) pick one or more stocks that will cut their dividends. By increasing my diversification, I minimize the effect that a dividend cut would have on my portfolio.

Dividend growth investors must focus on the dividend stream. If I have only about 10 stocks in my portfolio, a dividend cut from only one of them will cause my dividend stream to be decreased by 10% (assuming all my stocks have similar yields). It will take a while to make up for that loss. Conversely, if I have as many as 50, or even 100 stocks in my portfolio, a dividend cut by any one company will only cause a 1 or 2% hit to my income. This is something that can easily be over come the following year with the routine dividend growth I expect from the stocks I own.

There are, of course, problems with holding as many as 100 stocks in your portfolio. First there are the commission costs to purchase them all. But if one uses a discount online broker, one can minimize these costs to a manageable degree. I am fortunate enough to be able to buy stocks for only 3c per share. But even if I had to pay a $10 commission for 100 different stocks, this comes out to $1000. If my portfolio is worth $100,000 or more, then that is less than 1% of the funds, and since dividend growth portfolios should have relatively low turnover, this is not an expense that should ever have to be made again. If a portfolio is worth less then $100,000, then the commission costs would be more prohibitive, and someone would have to be more careful.

Now I'm not suggesting that I will go out and buy 100 different stocks all at once. If I choose to own that many stocks it's a number that I will accumulate over many years, so the commission costs will also be spread out over many years. And as a dividend growth investor, I plan on holding these stocks for a long time. After 15-20 years that initial commission cost will be (almost) insignificant. Also, since one of the reasons for owning so many stocks is to protect my income stream, the increased amount paid in commissions for so many stocks could be thought of as a one time insurance premium to be paid for that protection. I will always try to strive to keep commission costs as low as possible, but I will also be looking to maintaining enough diversity to protect the dividend stream. It is a balance we all must find for ourselves.

Second, it might be very difficult to keep track of 100 stocks. Some people recommend spending an hour a week following each of your stocks. This would, of course, be impossible if you own 100 of them. I, personally, don't think this is necessary. I have described my process for picking stocks in a previous article. Using David Fish's CCC list, it takes only a few minutes to narrow my choices down to a few hundred stocks I am interested in based on dividend history, yield, and growth rate. A quick look at the F.A.S.T Graph for each of these stocks will narrow the list down even further. Once I have bought a stock, I only need to watch for a dividend cut, freeze, or a significant slow down in the growth rate, to decide whether or not to sell it. This again can easily be found on the CCC list. As long as a stock I own continues to raise it's dividend at a rate I am satisfied with, I will continue to own it. So, in fact, it takes me very little time to keep track of my portfolio. Right now I own about 35 stocks. I will be adding more soon, and If I ever get to the point where I own 100, I think It will take me no more then one hour a week to satisfactorily (for me) keep track of them.

When investing, there are many things one must balance. How much diversification is right for yourself is just one of them. If you are a dividend growth investor, then I don't see any reason to hold less then about 20 stocks. Any less then that, and a dividend cut will too greatly affect your portfolio. And, to me, as long as you keep the commission costs down, and can find the time to adequately follow them, there is great benefit to holding as many as 100 stocks in your portfolio. The protection it will give you from dividend cuts will be worth it. Of course this is assuming that you can find that many stocks that are WORTH owning. Never sacrifice the quality of your holdings just to satisfy a feeling that you need to increase your diversity.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.