Dividend stocks can provide you with a steady stream of income and increase your exposure to capital appreciation. But how do you build a dividend portfolio that works?
Opinions about how to construct a dividend portfolio are as varied as there are investors. While that can create confusion, there are a few tips you can employ to navigate the dividend stock selection maze and generate favorable returns on your investment. These tips revolve around:
- The number of stocks you should hold in your portfolio.
- How those stockholdings should be diversified.
Whether you are interested in generating regular income in retirement or seeking a steady flow of passive income, this article discussed vital guidelines to help you make the right decisions in constructing your dividend portfolio. But first you know why building a portfolio is better than picking one or two stocks and then banking your investment hope in them.
Why build dividend portfolio?
Building a portfolio helps you to diversify risks. Investing involves a great deal of uncertainties and risks and that explains why even veteran stock investors are said to be wrong at least 40% of the time.
If you put all your eggs in one basket, the risk of you permanently losing the capital you invested is vastly heightened. But if you diversify your portfolio, under-performance in one of your holdings can be offset by out-performance in the other holdings. That way you lower your investing risks and also maximize potential return on the investment.
A diversified portfolio can weather many storms most of the time compared to a sharp-pointed investment in one or two companies. Therefore, building a portfolio is a great way to get closer to your investment objective. In the case of dividend investing, understanding why you need to diversify your portfolio should set you on the right path in picking the right stocks to hold.
4 factors that influence portfolio performance
There are a number of factors that will almost always influence the return of your portfolio relative to the broader market. But here are the four most important risks factors to consider when constructing dividend portfolio:
- The number of stocks in your portfolio.
- The relationship between those stocks.
- The amount of financial leverage of each stock.
- The market cap of each stock.
It is important to note that the impact of these risk factors can be more pronounced in times of market turbulence. One sector that has recently seen much turbulence is energy and investors with poorly constructed portfolios are counting losses.
It was rosy for energy investors two years ago when oil prices were chasing $100/barrel. But as demand waned amid global crude oversupply, oil prices came down crashing and portfolios highly exposed to energy got incinerated. Much of the impact from crude oil price fallout has fallen on the small energy companies that are struggling to get credit.
But there is a way you can avoid being caught in such problems that can destroy your investment. It starts by seeking answer to some vital questions:
1. How many stocks should you hold?
You find that many successful investment veterans have a tendency of building what can be called concentrated portfolios. This is a construction where say top 10 stock picks make up more than 65% of the portfolio value. But again you realized that those highly successful investment professionals such as Warren Buffett have resources and connections that enable them to invest with conviction in their best stock ideas, yet most individual investors do not enjoy those advantages.
If you cannot match Buffett’s connection, insights and resources to build a concentrated portfolio, there is a way you can compensate for that shortage: Spread your bets over a range of stock picks. By choosing to spread your investment over several stocks, you also keep clear from risks associated with concentrated portfolios. It is not every day that a concentrate portfolio wins, and when it fails, the impact can be devastating.
The warning about concentrated portfolio strategy is that while it works for some, it doesn’t work for everybody and it can turn sour and burn all your invested capital if you don’t have what it takes to do it properly.
Now that you know that a carefully spread portfolio can generate rich rewards, it is time to ask how many stocks you should hold. It has been established that the fewer the stocks you have in your portfolio the greater your portfolio is likely to deviate from the market return and the opposite is true.
As such, you should spread your investment over a reasonable range of dividend stocks. But exactly how many dividend stocks you should have in your portfolio to maximize the benefits of portfolio diversification is a decision you have to make carefully. Luckily, a number of researchers have attempted to help individual investors get a rough idea about the number of stocks they should strive to hold in their portfolio.
According to a research article published by the American Association of Individual Investors (AAII), the annual volatility of your investment is elevated by about 30% if you only hold a single stock. In other words, holding only one stock would mean that some years you would outperform the market by about 35% and in some years you would underperform the market by the same degree.
Going deeper, the AAII article shows that owning 25 stocks in your portfolio reduces you diversifiable risk by about 80%. If you own 100 stocks in your portfolio, the diversifiable risk is reduced by about 90%. Holding 400 stocks would narrow your diversifiable risk even further by up to 95%.
Another study released as recently as 2014 also offered insight into how individual investors can reduce risks and maximize returns. The study showed that during financial turbulence, investors need a larger number of stocks to reduce their diversifiable risks.
In a normal economic environment, the study found that a U.S. investor needs an average of 55 stocks in their portfolio to be confident of eliminating 90% of diversifiable risk at 90% of the time they make an investment. However, when the market is in distress, the average number of stocks needed to achieve that level of risk reduction could double to 110 stocks or even more.
What do you draw from the two studies?
If you look at the two studies closely, the information you get is that holding between 25 and 100 stocks provides an individual investor with a reasonable room to reduce diversifiable risks. However, it is important that an investor knows other unique factors that could influence the performance of a dividend portfolio.
Some of these factors include:
- The cost of trading
- The amount of time the investor can devote to research
- And size of the picks.
When you have a small portfolio, the impact of trading cost on your total return will be greater compared to when you have a large portfolio. Some individual investors with small accounts have found that they can get over this problem by investing in dividend ETFs. Investing in ETFs not only save you trading costs but also helps you to diversify your portfolio by default.
2. How should your dividend portfolio look like?
Having a large number of shares can provide diversification benefits. But care needs to be taken when selecting individual stocks to add to your portfolio because a poorly selected portfolio can still disappoint you no matter how many stocks you hold.
Picking stocks with the same characteristics can undo the benefits of portfolio diversification. You find that stocks in the same industry are highly correlated and are affected by the same factors that in the end cause them to move in the same direction. It is great if the direction of the movement is upward, but there is no guarantee that they will keep moving up forever.
If you make you portfolio picks from different sectors, the risk is diversified because when some sectors are in a crisis, others could benefit from that same crisis and offset the impact from the distressed industry. Perhaps the best guide when it comes to sector diversification is that you should not invest more than 25% of your portfolio into a single sector. Because you can never tell which sectors would reward or disappoint over a given period of time.
You are better off maintaining a fairly diversified portfolio. But even when it comes to sector diversification, you should be careful not veer off what you might consider your comfort zone. Your investment still needs to be guided by attractive stock prices and other valuation metrics even as you seek to construct a sector-diversified account.
3. Should you pick large or small-cap stocks?
Stock prices of small-cap companies tend to be more volatile compared to large-cap companies. These companies also tend to have fewer people trading them and that can complicate moving in or out of a position if you have filled your portfolio with small caps.
The high volatility of small-cap stocks also means that they can significantly under-perform or outperform larger-cap counterparts depending on the market environment. The volatility in small-cap stock is also caused by the fact that their business is less established or diversified.
But there is more on price volatility:
It is important for dividend investors to understand price volatility (beta). Beta is the measure of the volatility of stock price. The market has a beta of 1.0 and volatility of individual stocks is measured on the basis of how much they move away from the market beta. As such, a stock that moves less than the market will have a beta of less than 1.0 and a stock that moves more than the market will have a beta of more than 1.0.
You find that small-cap stocks with less predictable business model and high level of financial leverage with usually exhibit a higher beta. The opposite is true for large-cap, more established companies.
Understanding beta can help investors eliminate some investing risks and enhance their returns given that different investors have different emotional tendencies and risk appetite. Perhaps the point to note here is that a portfolio laden with stocks with beta of more than 1.0 will have greater performance deviation compared to a portfolio that contains stocks whose beta is less than 1.0. But again, lower or higher beta has doesn’t guarantee that an investment will be successful or not over a five-year period.
4. Ready yourself for the long term:
If you are into long-term investors, you should act like an athlete running a marathon rather than one doing the sprint. As such, your strategy should be to identify compelling stocks with growing business model and trading at attractive prices and then hold them for long.
You should never forget that constructing a dividend portfolio is art as it is science. Never jump into a stock or sector until you are aware of your risk tolerance, financial goal and the amount of capital you have for investing.
Always remember that time, risk, and return are all intertwined.