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
I’ll explain.
Let’s use Singapore as an example. Every year, Singapore rains half the time, and the other half it’s sunny.
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
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
What Do Smart Investors Know That Beginners Sometimes Lack?
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
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
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