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?
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 to take.
Once I have settled on an ideal number of holdings to own, I prefer to equally weight my positions. It is very difficult to know which stocks will go on to be the best long-term performers.
Risk Factor 2: Industry Diversification
While owning a greater number of stocks can provide diversification benefits, many investors still end up with poorly diversified portfolios because they are drawn to particular types of stocks (e.g. consumer products with familiar brands) or investing “rules” (e.g. only buy stocks with price-to-earnings ratios less than 12x).
Unfortunately, owning a number of stocks that have similar characteristics does not provide adequate diversification.
This is because stocks from similar industries are often sensitive to the same factors and move together in the market (i.e. they are highly correlated).
If a shared factor such as interest rates or the price of oil becomes unfavorable, your portfolio could significantly underperform the market.
Picking stocks from different sectors and industries helps diversify away this risk because when some sectors are struggling, others are likely doing well.
The pie chart below shows the sector breakdown of the S&P 500. You can see that only one sector accounts for more than 20% of the overall market (Information Technology).
My personal preference is to invest no more than 25% of my portfolio into any single sector, and I try to own blue-chip dividend stocks with little overlap in their actual operations.
Sector diversification is important because you never know which areas of the market could come in or out of favor.
As seen below, a portfolio invested completely in energy stocks would have returned -4% over the last five years, underperforming the S&P 500 by 72%.
On the other hand, a portfolio consisting completely of healthcare stocks would have gained 110%, beating the market by 42%.
No one knows which sectors will be the best and worst performers over the next five years, which is why maintaining a reasonable level of diversification is important.
Importantly, sector diversification should not come at the expense of violating valuation principles or extending outside of your circle of competence.
Just because consumer staples accounts for 10.1% of the S&P 500 doesn’t mean you must buy a stock in that sector if you cannot find one that is attractively priced.
Equally important, you should not diversify into a sector or industry that is outside of your comfort zone.
For example, many conservative dividend investors remain underweight the technology sector because its pace of change is too fast. Trying to predict which tech companies will still be relevant in five years can be challenging.
The takeaway is that you should be intentional with your diversification across sectors and business models, but you don’t need to play everywhere. Stick to areas of the market you are comfortable with and use common sense as you look to diversify.
Risk Factor 3: Financial Leverage
Financial leverage magnifies returns received by equity holders and is one of the key factors to be aware of when searching for safe stocks. The more debt a company has, the more the price of the stock can fluctuate depending on business conditions.
As such, companies with large debt loads and more cyclical business models usually have more volatile stocks.
If interest rates ever rise and credit conditions start to tighten, some of the lower quality, highly levered firms could run into trouble.
When constructing a portfolio, it’s important to be aware of the overall credit quality of your holdings.
For most types of businesses, I prefer to see a debt to capital ratio of no more than 50%, healthy free cash flow generation, and strong coverage ratios (e.g. net debt / EBIT of less than 5x). These are some of the most important financial ratios to understand.
Risk Factor 4: Size Matters
Historically speaking, companies with small market caps have exhibited greater stock price volatility than large cap stocks.
The bigger the company, the more buyers and sells there are to trade shares back and forth. The availability of buyers and sellers is known as liquidity.
When you enter an order to buy or sell shares of Coca-Cola, someone has to be on the other side of the trade and agree to your asking price for the trade to execute.
Small cap companies (i.e. stocks with market caps under $2 billion) can have much less liquidity compared to large cap companies.
With fewer buyers and sellers, it is not always as easy to move in and out of positions, and the spread between the price that a seller is asking for and the price a buyer is willing to pay can become very wide.
With less trading liquidity, small cap stocks can significantly outperform or underperform large cap stocks in different market environments.
Small cap stocks are also more volatile because their businesses are often less diversified and established than large caps.
As seen below, the Russell 2000, which contains mostly small cap stocks, exhibited significantly greater volatility (standard deviation) over the past decade than the Dow Jones and S&P 500.
Expect your portfolio to also demonstrate greater volatility if it is mostly composed of small cap stocks.
Price Volatility and Time Horizon
In addition to the four risk factors mentioned above, investors should understand beta (price volatility) and take advantage of their long-term holding periods to improve their dividend portfolios.
Beta measures a stock’s price volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market.
A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock’s beta is less than 1.0.
A stock’s beta is largely determined by some the risk factors mentioned above. Smaller companies with high amounts of financial leverage and less predictable business models will usually have higher betas.
While beta is backwards-looking (i.e. a stock with low price volatility historically will not necessarily have low volatility going forward), it is still helpful for investors to understand since we each have different risk tolerances and emotional tendencies.
A portfolio filled with stocks that have beta values greater than 1.0 will likely whip up and down much more than a portfolio filled with low beta stocks.
Importantly, beta is based on relatively near-term price volatility ignores underlying business fundamentals.
In other words, for long-term focused dividend investors, a high or low beta does not indicate whether or not an investment will be successful over the next five years.
As individual investors, one of our biggest advantages is being able to hold stocks for much longer periods of time to let their strong underlying fundamentals eventually be reflected in the stock’s price.
As you build up your portfolio, remember you are running a marathon, not a sprint.
It is generally better to own shares of a quality, growing business trading at a reasonable price than remain on the sidelines trying to time the market or play the quarterly earnings game. Let your long time horizon work for you.
Building a dividend portfolio is part art, part science. Constructing an optimal portfolio largely depends on an individual’s goals, risk tolerance, and available capital.
When it comes to dividend investing, building and protecting a nest egg is goal number one, followed by generating a stream of safe, growing passive income.
Understanding the key risk factors influencing a portfolio’s returns and volatility can help us avoid taking unnecessary risk.
The following risk factors are worth remembering:
- The greater number of uncorrelated stocks you own, the less diversifiable risk remains
- Depending on portfolio size and research time constraints, owning 20 to 60 stocks seems reasonable for most investors
- Stocks should be diversified across different sectors and industries
- Small cap stocks are more volatile than large cap stocks
- Stocks with high financial leverage are more volatile and create greater risk for shareholders
- A stock’s beta tells you how volatile the stock has been relative to the market
- Investing with a time horizon measured in months or quarters is speculating
Keeping the above factors in mind, you should review your personal goals. Are you nearing retirement and looking to create a safe and steady stream of income to live off of?
Are you investing for your grandkids, looking for more balance between income and long-term capital appreciation?
What is your risk tolerance? How much time are you willing to commit to stay current with your portfolio?
Answering all of these questions will influence how many dividend stocks you choose to buy and the characteristics of each stock (e.g. dividend yield, price volatility, Dividend Safety Scores).
For investors interested in reviewing the risk profile of their existing dividend portfolio, you can input your holdings in our Portfolio Analyzer tool to see your diversification by stock, sector, dividend income, and more.