fbpx
Willie Keng, CFA

Willie Keng, CFA

Chief Editor

How to Safely Build a Long-Lasting Dividend Portfolio 2020

Not many understand this. But this is the most reliable way to reduce risk in your portfolio.

1. Here’s The Essential Ingredient You Need

This is why most investors fail. 

Because they’re are not doing this correctly. And what you might read on online these days give very vague advice on how to build your dividend portfolio.

You see, the thing about successful wealth building all starts with one essential ingredient. 

I know there’re many views here. But I can tell you for a fact, that in my opinion, the only thing you need, before anything else is getting your portfolio diversified

That’s the most reliable way to reduce risk in your portfolio. And safely build a long-lasting dividend portfolio. It’s as simple as that. 

 

Results: You Make Your Portfolio Make More Money

Now, I’m not exaggerating here. When your portfolio is diversified, you’re protected against the dangers of losing money over the long term. And if you know how to do it right, you’re going to make even more money than anyone else. 

And I’m going to show you how today. 

You might want to hear about this famous fund manager first. His name is Peter Lynch, Fidelity Investment’s most famous fund manager. Peter Lynch ran the Magellan Fund between 1977 to 1990, growing it from a mere $18 million to massive $14 billion. Here’s what’s even more impressive — during those 13 years, he made 29% annual returns on the Fund. This was despite all the crisis he faced — “savings and loans” crisis in 1980, Black Monday in 1987, “junk bond” crash in 1989. The fund’s returns were nearly twice the 16% returns on the S&P 500. It was the best performing fund in the world.

Now, between you and me, what many did not know is it wasn’t just his famous “invest in what you know” principle which led to his huge gains. You see, when Peter Lynch took over the Magellan Fund, he raised the number of stocks from 40 to 60, then six months later — 100 to 150 stocks. He was so convinced on diversification, he had more than 1,000 stock positions in the fund. At one time, he owned as many as 1,400 stocks. 

But you don’t have to invest like him.

Your see, what he’s doing here is spreading his money across many different stocks. This way, he significantly lowers the risk of losing money. That’s how he’d achieved his huge gains.

In my opinion, Peter Lynch is one of the best guys to look after other people’s money. And he suggests individual investors need not diversify like him. But he warns against investing heavily in just one stock.

And I fully agree with him. It’s a smarter way of investing. Just think for a moment — You don’t have to feel frustrated when a few of your stocks gone wrong, or be worried when the next crisis comes. You’re going to make way more money safely, reliably and more importantly, profitably. Just like Peter Lynch.

 

Why Diversification is Easy and Hassle-Free

This will be valuable somewhat. And I want you to follow me on this, because not many people get it.

I’ll explain. 

Let’s use Singapore as an example. Every year, Singapore rains half the time, and the other half it’s sunny.

So you decide to invest in two businesses, one a raincoat maker. The other, a theme park business. Weather affects profits of both businesses. 

When it’s sunny, the theme park is crowded. It’s a booming business because everyone wants to enjoy the good rides on a bright, sunny day.

Now, when it’s raining, the theme park does poorly, while the raincoat maker does very well. So raincoat sales now goes up. And theme park loses money.

This is a basic way of diversification. If you’d invest in either the raincoat or theme park business, you’ll be making money half the time. But losing money on the other half (remember, you still need to run the business for the entire year)

So, to reduce this risk, you buy into different businesses. And it’s easy to do this, so long you’re willing to put your money in different businesses. It’s a free way to reduce risk.

Of course, sometimes both businesses don’t do well and you lose money.

Here’ the important kicker —  That’s why you don’t diversify with only two businesses. It’s common sense. You need to understand that the best way to safely build a long-lasting dividend portfolio is to buy many different businesses. This is to avoid shooting yourself in the foot when a concentrated bet goes wrong.

2. How to Use a Nobel Prize-Winning Method to Diversify

You can find a lot of research and academic studies done on portfolio diversification over the last 50 years. But without getting too caught up in the details, diversification is not about owning just 5 to 10 stocks.

Economist and Nobel-Prize winner, Harry Markowitz, published in the Journal of Finance in 1952 on “Portfolio Selection” about using diversification. He wrote about how investors can create diversified portfolios to “maximize their expected returns for a given level of risk.”

Burton G. Malkiel, who famously wrote A Random Walk Down on Wall Street, backed Markowitz’s theory. Burton mentions: “…the golden number is at least 50 equal-sized and well-diversified US stocks… With such a portfolio, the total risk is reduced by over 60%… further increases in the number of holdings do not produce much additional risk reduction.

Many investors, including Peter Lynch, took this concept of diversification seriously. 

Even Warren Buffett, who claims he doesn’t diversify, actually buys many companies under Berkshire Hathaway. And I’m not surprised here, especially when you’re running a $800 billion dollar investment company. 

You see, Berkshire Hathaway owns over 40 different companies. And that’s not including his more than 60 over private businesses. So you see, the rich diversifies to get richer. And they do it well.

Now, according to American Association of Individual Investors (AAII) Journal’s article — “How Many Stocks Do You Need to Be Diversified” by Daniel Burnside, points out: “A single-stock investor will experience annual returns averaging a whopping 35% above or below the market — with some years closer to the market and some years further from the market.”

The research continue to explain, as broad principle, diversifiable risk will be reduced by the following:

  • Holding 25 stocks reduces diversifiable risk by 80%
  • Holding 100 stocks reduces diversifiable risk by 90%
  • Holding 400 stocks reduces diversifiable risk by 95%

From Markowitz’ and AAII’s study, a healthy number an investor should responsibly own is 25 to 100 stocks. Adding more have little diversification benefits. Of course, you also need to consider your own financial situation, time for stock research and the size of your wealth. 

In other words, the more stocks you own, the less time you have to understand each stock in detail.

 

Hint: You Don’t Have to Be Right 100% of the Time 

I know it’s highly subjective here. And everyone has a different number in mind. But I believe, based on my experience, holding around 30 equal-sized stocks provides a reasonable balance. This way, you not only get to enjoy most of the diversification benefits. But have enough time to eyeball your stocks. What’s more important here — You don’t have to worry or feel stressed if one or two stocks aren’t performing.  

Famous stock-picker, John Templeton often said he’s right about his stock picks only around 60% of the time. And has accumulated one of the best track records in the business

Once you’ve settled on your ideal number of stocks to own, what I suggest is this — Have an equal amount of money allocated to each stock. Because you never know which one will be the best long-term performer. 

Example — If you’ve $500,000 to build your dividend portfolio, you’d probably allocate $17,000 for each stock. 

And when you buy into a stock, don’t put all your $17,000 immediately. Buy it over a period of a few months.

So far so good? Let’s go deeper down the rabbit hole.

 

3. Try This Simple Way to “Crisis-Proof” Your Portfolio

I’ve many people come up to me telling me: “Willie, I’ve diversified like what you said, but I still lose money…” 
 
What’s going on here?
 
You see, I’ve noticed many investors invest in what they’re familiar with. It could be investing only in a certain industry like REITs, or they buy just bank stocks, or prefer to own consumer stocks. Sometimes, investors might buy stocks based on a certain “rule”  — “own dividend yield stocks of at least 5%”, or “sticking to local stocks”. These are very common mistakes. 
 
Because buying 30 REITs or 30 bank stocks will not protect you against a major property or another financial crisis. Let me explain.
 
Remember the raincoat maker and theme park business earlier? Well, different businesses behave differently at certain periods. And if you think about it, some stocks you buy today can outperform the rest in one period, but underperforms in the next. 
 
During the Lehman Brothers crisis, many bank stocks, and even REITs greatly underperformed the market. But there were many other stocks which outperformed the market back then.
 
And it’s not just stocks alone. Different asset classes — whether it’s bonds, gold, foreign exchange all behave differently from each other. In Wall Street words — they aren’t highly correlated to one another. 
 
You see, stocks in the same industry share certain, similar traits — It could be interest rates, or gold prices. For example, if you’d buy only oil stocks, your portfolio could be sensitive to the price of oil. Or if you buy only property stocks, your portfolio could be sensitive to huge moves in interest rates. And you know what’s next? An oil crisis or a property crisis will simply sabotage your portfolio. 
 
So, do a quick check here. If your portfolio is affected by one or two shared traits — Like the price of oil, interest rates, property prices, I suggest to start picking stocks across different industries. This will simply prevent your portfolio from breaking if a crisis comes.
 
 

What Do Smart Investors Know That Beginners Sometimes Lack?

I’ll digress a bit here. You see, crisis are never permanent. And the smart investors know that the stock market moves even higher after every crisis. To quote billionaire investor, Howard Marks in his letters to shareholders: “Cycles are self-correcting.” You’ve to know that some industries may go out of favor today, but will eventually outperform later on. 
 
Think about the tech stocks, banks, REITs, commodities. At the end, they’ll all move in an up trending cycle. 
 
My preference for you is to invest not more than 25% of your portfolio into a single industry. This will not only “crisis-proof” your portfolio, it’s going to make you sleep better, and feel more confident investing.
 
Just to give you a reference of all the industries in the stock market. I’m using the S&P 500 breakdown. You can view a more detailed breakdown here.

 

Source: Standard & Poor’s

And don’t be afraid to step out of your circle of competence. Just because you won’t know the insurance industry, doesn’t mean you don’t invest in insurance stocks. And always be expanding your circle of competence.

Ok, so back to portfolio diversification. Between you and me, if you’d stick to buying a basket of 30, equal-sized stocks, across different industries… 

You’ll be better than 99% of stock investors out there.

 

4. You Need to Avoid High Financial Leverage

Let’s take a break and talk about something else. Because this is crucial to building your dividend portfolio.

Incidentally, as a bonds analyst, I believe one huge mistake which kills many investors is this — They buy companies with a high level of debt. In Wall Street words — high financial leverage.

You might think having a high leverage allows you to make more money, and get a higher return on your investment. But only when times are good. The problem here is, companies can also go bankrupt quickly if things go wrong

And it happens. The more debt a company has, the more sensitive it is to a crisis. If a company isn’t doing well, its high debt will greatly affect profits. This is because the company has to worry about paying interests and repay their debt even in bad times. The stress on profits makes its stock price very volatile.

As far as I’m concerned, building a safe, long-lasting dividend portfolio is to avoid high financial leverage.

Here’s one quick tip you can use. You need to look at a company’s balance sheet. Then check it has little or no debt. It’s very simple. I prefer to see debt to equity ratio of no more than 100%. And make sure the balance sheet holds a lot of cash too. This is also one of the 9 critical steps our Dividend Titan Master Toolkit. 

 

5. Why Size Matters for Your Dividend Portfolio

Research has shown that small cap stocks (less than $2 billion market cap) have greater price volatility than large cap stocks (more than $10 billion market cap). Look at the Russell 2000, which makes up of  small cap stocks. It has shown far more volatility than the S&P 500 Index below. 

The higher the graph, the more volatile. This means stock price can fluctuate greatly, which makes it riskier for your portfolio. 

Source: Bloomberg, CME Economic Research

You want to make your dividend portfolio safer, by filling it with large cap stocks. And you can find many solid, dividend growers amongst the large cap stocks.

One important point you need to know here. Large cap stocks have high trading volume (high liquidity). This means there’s always someone willing to sell and buy these large cap stocks from you. 

On the other hand, you might find it hard to sell a small cap stock, because there’s fewer buyers and sellers trading the stock. The trading volume is weak. This can be a concern especially if you need to sell stocks urgently to meet your cash needs.

Hint: You might want to narrow your focus to large-cap stocks if you’re just starting out building your dividend portfolio.

 

Conclusion — Build Your Dividend Portfolio The Right Way 

You know, I can’t stress how strongly I feel about this — Diversifying your dividend portfolio, avoiding highly leveraged companies and picking the right size. These are probably very valuable things you need to know. 

And the odd thing, many investors don’t practice this enough. Either that, they’ve been doing it wrongly. 

You see, if you build your portfolio this way, it’s going to give you a safe, long-lasting dividend portfolio. And it’ll vastly improve your investment returns. 

As far as I’m concerned, it drains off all the fear, anxiety and concerns about market crashes and picking the wrong stocks. And more importantly, it provides you the most reliable way to grow your dividends in retirement.

That’s it for now.

Always here for you,

Willie Keng, CFA

 

Editor’s Notes: I invite you to join our growing community simply by subscribing for our completely FREE email list. In it, you’ll received some of our best ideas about how to protect and grow your wealth safely. And if you want go down the rabbit hole of becoming a dividend investor fast, I’ll show you behind-the-scenes some of these solid, dividend growers using a Power Stack of proven recipe to accelerate your financial goals. It’s risk-free anyway. Nothing to lose. 

Willie Keng, CFA

Willie Keng, CFA is the founder of Dividend Titan, a financial publication for self-managed investors. A former research analyst for top private banks, Willie today runs his own consulting firm. Some of his clients include asset managers and family offices. Willie has a deep passion for helping everyday investors take control of their financial future. And has spent over 10,000 hours researching, analyzing and recommending investment ideas.

Subscribe
Notify of
guest
0 Comments
Inline Feedbacks
View all comments

Share this post

Share on facebook
Share on twitter
Share on linkedin
Share on whatsapp
0
Would love your thoughts, please comment.x
()
x

Live Off Dividends in Your Retirement Safely.

My Free Insider’s Kit will show you exactly how to protect and grow your wealth the smart way.