I previously wrote an article about measuring and managing dividend stocks, but have you ever wondered how to build a dividend portfolio in the first place?
Like most things with investing, everyone has their own opinion about how to construct a portfolio. Most of the debate usually centers on how many holdings an investor should own and how their holdings should be diversified.
While there is no right or wrong answer, I believe there are general guidelines that investors should remain aware of to avoid taking unnecessary risk with their dividend portfolios – especially for those living off dividends in retirement.
In this article, I will review the key factors that influence a portfolio’s risk profile. Let’s start with a basic understanding of why a portfolio is important in the first place.
A Portfolio Diversifies Risk
Why should investors build a dividend portfolio instead of investing completely in one or two companies that they really like?
[drizzle]For one thing, investing involves a tremendous amount of randomness and luck. Even the “best” professionals are wrong at least 40% of the time.
If we invested all of our cash into a single company, even one with seemingly “low” risk, we will likely generate returns that are significantly different than the market’s performance – for better or worse.
Many investors do not have the stomach for this level of volatility, especially since there are a number of unexpected events that could occur to put your capital at risk of being permanently lost.
Remember Enron? What about Lehman Brothers? Going “all-in” on any one company can have disastrous consequences.
On the other end of the spectrum, suppose you bought shares of every stock in the market. For every company in your portfolio that experienced bad news, you would likely own just as many businesses experiencing unexpectedly good news.
In other words, you would no longer be dependent on any single stock to drive your investment returns and dividend income. Your portfolio could weather a few unanticipated storms because it was diversified across a number of different companies.
So long as our country continues to survive and advance, there would be virtually no chance of your portfolio experiencing a permanent loss of capital – the market has historically appreciated over long periods of time and will likely continue to do so.
It’s obviously impractical for an individual investor to buy shares of every company in the market without the use of exchange traded funds (ETFs), but you can understand the advantages of owning more than just a couple of companies.
Properly constructed portfolios can help us diversify away risk and get closer to our objectives. Building a dividend portfolio starts with an understanding of the main risk factors that influence a portfolio’s returns and volatility.
Key Risk Factors to Consider
In my opinion, the four most important factors that will influence the volatility of your portfolio’s return relative to the market’s return are: (1) the number of holdings; (2) the correlation between holdings; (3) the amount of financial leverage each holding has; and (4) the market cap size of each holding.
Each of these risk factors can significantly impact a portfolio’s performance, especially during turbulent markets.
Investors are often unaware that they are making a factor bet with their portfolios until it works against them.
For example, suppose half of your portfolio was invested in small cap energy stocks with high financial leverage.
Until late 2014, your portfolio probably enjoyed excellent returns and low volatility as oil prices and production increased.
It’s only human nature to attribute good results to our own skill rather than luck. However, this portfolio was nothing more than a factor bet on energy and favorable credit markets.
Now that the price of oil has collapsed and credit is less available to small energy firms, this portfolio would have been walloped.
The point of building a portfolio is to diversify away these factor bets, which we cannot control or forecast, and focus our returns on the performance of individual companies.
Risk Factor 1: How Many Stocks Should I Own?
Many of the best investment professionals run concentrated portfolios (e.g. top 10 stocks = 65%+ of the portfolio’s value). They invest with conviction behind their best ideas.
For example, Warren Buffett’s dividend portfolio has several holdings that exceed 10% of his portfolio’s overall value.
As an individual investor, I certainly do not have Warren Buffett’s resources, connections, and insights needed to responsibly run a concentrated portfolio.
For that reason, I prefer to spread my bets over a reasonable range of different stocks to avoid shooting myself in the foot with a concentrated bet that turns sour.
The fewer stocks you own, the greater your portfolio can deviate from the market’s return. So how many dividend-paying stocks should you own to maximize the benefits of diversification? Plenty of academic studies have tried answering this question over the last 50 years.
The American Association of Individual Investors (“AAII”) wrote an article citing that “holding a single stock rather than a perfectly diversified portfolio increases annual volatility by roughly 30%…Thus, the single-stock investor will experience annual returns that average a whopping 35% above or below the market – with some years closer to the market and some years further from the market.”
The AAII study went on to state that, as a rule of thumb, diversifiable risk will be reduced by the following amounts:
- Holding 25 stocks reduces diversifiable risk by about 80%
- Holding 100 stocks reduces diversifiable risk by about 90%
- Holding 400 stocks reduces diversifiable risk by about 95%
A more recent study was released in late 2014 in a paper titled, “Equity Portfolio Diversification: How Many Stocks are Enough? Evidence from Five Developed Markets.”
Notable findings were that a greater number of stocks are needed to diversify risk during periods when markets are in financial distress – correlations between stocks are often the highest in this type of environment.
Within the U.S., the researchers concluded that, to be confident of reducing 90% of the diversifiable risk 90% of the time, the number of stocks needed on average is about 55. In times of distress, however, it can increase to more than 110 stocks.
From these two studies alone, it would seem responsible to own between 25 and 100 stocks. However, in addition to the math behind diversification, investors should also consider factors unique to their personal financial situation – the size of their portfolio, willingness to devote time to research, trading costs, and more.
The smaller your portfolio, the greater the impact trading costs will have on total returns. Investors with small accounts should consider buying dividend ETFs instead of individual stocks to save trading costs and achieve diversification.
The more positions you own, the less research time you will have to devote to knowing your companies really well.
While it is highly subjective, I believe the relationships between portfolio value and the number of holdings in the table below provide a reasonable balance between the need for diversification, a desire to keep trading costs low, and a limited amount of research time to devote to maintaining a portfolio.
At the end of the day, each investor has a unique opinion on how much diversification is “enough” and how much risk they are willing