When building a portfolio, many aspects must be considered by income investors. So far in our series, entitled: The Income Method, we have covered
- How we determine our target yield for the model portfolio
- How we pair securities to create strong hybrids
- How we employ portfolio rotation to ensure a strong and healthy portfolio
- We also examined how reinvesting dividends using our method produces an ever-growing dividend stream
Today we want to touch on a topic we often get asked about - diversification. Why do we encourage diversification and how does it help you? We sometimes get asked privately why not pick just one fund - like Oxford Lane Capital (OXLC) yielding 15% or Eagle Point Credit (ECC) yielding 13.8% - if it is an excellent choice instead of consistently encouraging investors to hold at a minimum 40 positions. The key reason is that while we can analyze a security to death, there are still events and market movements that are outside our control. A diversified portfolio allows us to create the yield we want while limiting the impact of the occasional mishap. 40 also fits our sweet spot that gives us great diversification without getting overwhelming.
Portfolio Allocation Limits
Typically within a diversified high-yield portfolio (in the case of High Dividend Opportunities, our "Model Portfolio"), we set our suggested allocation to 2% for individual securities - this would require 50 individual positions to achieve a full 100%. We also have higher allocation limits for many bonds, baby bonds, and funds (high yield CEFs, and ETFs). The reason for this is that these securities are often lower risk and in some cases also provide internal diversification in case of closed end and exchange traded, funds - CEFs and ETFs.
We also recognize at times investors may choose to overweight a specific security in their portfolio. Many of our authors at High Dividend Opportunities are over the 2% standard limit in CLO funds. We all strongly believe in their income generation and durability.
Reasons we often overweight a specific security are:
- The risk is lower compared to other holdings
- The security was mispriced when purchased and has rapidly increased in value (was within allocation at purchase)
- The security offers superior access to investments outside of normal reach and is internally diversified.
While this list is in no way exhaustive, it highlights reasons why you may elect to overweight any specific investment. By picking 40 minimum securities, it leaves you 20% of your portfolio allocation to overweight securities while still providing a strong footing across the market.
Tracking 40 Securities Is Easier Than It Looks
Another often raised concern relates to our advice for income investors to hold at least 40 individual high yield positions. Some think it would be extremely difficult to follow this many tickers. While we recognize that not everyone has the experience and time that we do in the market, this number is actually easier than it appears. At High Dividend Opportunities we are currently recommending to allocate of 35%-40% of our portfolio to fixed income style securities. This means approximately 12-16 securities will be this style in a portfolio of 40 choices.
These securities are often lower risk and require minimal following when issued by a highly reliable company. We actively track all of our preferreds and bonds, but even a semi-annual to yearly check is all that is required for many choices.
For example, we recommend RLJ Lodging Trust, $1.95 Series A Cumulative Convertible Preferred Shares (RLJ.PA) which yields 7.3% and has it dividends covered by over 10X. It cannot be called and pays a steady yield. Here, little to no maintenance is required.
We also recommended B. Riley Financial, 6.75% Senior Notes Due 5/31/2024 (RILYO), which by virtue of having very well covered interest payments, is also another low maintenance pick.
Holding baby bonds, preferreds and bonds allow you to reduce the time it takes monitoring your portfolio's individual positions while also providing you strong recession resilient income. Interest rates will eventually be cut, but the yield on those two highlighted choices above will remain stable.
Be Di-vers-ified, Not Di-worse-ified
When growing your portfolio, an income investor should not invest in additional securities just to do so. While this will seem extremely obvious to many of you, it needs to be mentioned. Diversification for the sake of diversification is often futile. Careful forethought, planning and research should be done prior to taking on any position. If you do not find 40 worthy positions, invest in the ones you have found and build up to the 40 position mark over time. This will ensure you're not growing your portfolio with weak links. Although it will increase your risk and volatility in the shorter term, the longer term benefits of having solid choices outweighs this.
Many of our new investors at first are eager to jump right in and invest all of their money into our positions and this is exciting, but we encourage them to buy their positions in waves of 0.5% to 1% of their portfolio allocation to capture the best prices. Set a limit order and let the market come to you.
Today we've reviewed the Rule of 40. 40 unique individual positions to maintain a level of security, safety and recession resilience. Many income investors neglect a healthy level of diversification. While we acknowledge that this level may remove the potential upswing from price movements, it also prevents the potential crash with the market as fixed income such as bonds tend to go up in price when equities pull back. Our goal remains the same: Safe and reliable high yield immediate income to live off of or reinvest.
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Disclosure: I am/we are long OXLC, ECC, RILYO, RLJ.PA. 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.