Dividend Champion Diversification

Nearly anything we do carries with it a level of risk.  Risk is an inherent part of life we accept.  We learn to mitigate or transfer it in a variety of ways.  We use seat belts when driving (mitigation) and purchase home owners insurance (transference).

Investing also presents risk to the investor.  As Dividend Farmers, it’s our job to mitigate the risk while maximizing our result.  One way of reducing our investment risk is to spread our money across multiple investments with different characteristics. 

Instead of putting all our money in the Blue Sky Co. and watching it vanish entirely if Blue Sky crashes, we allocate or diversify our resources across firms in various sectors or industries.  Doing so ensures that if one firm becomes insolvent it doesn’t take our full investment down with it.

Spread your investments to reduce risk.

One way to diversify a portfolio is to select a variety of Dividend Champions.  The first chart below offers a list of the 5 most commonly found sectors among the Champions list from 1/31/19. 

Sectors represent broad cross-sections of company types from which to choose.  For instance, the Financial sector is heavily represented with 33 different banks and insurance firms among those growing their dividends for 25 or more consecutive years.  The Industrials sector includes Aerospace, Machinery, and Commercial Services firms conforming to the 25 year minimum dividend growth history.  

Top 5 Dividend Champion Sectors

Sectors	Champions	Representation
Financials	33	Banks & Insurance
Industrials	25	Aerospace, Industrial Conglomerate, Machinery, Commercial Services
Consumer Staples	17	Food, Household Products, Tobacco
Utilities	16	Electric & Water
Materials	11	Chemicals, Containers & Packaging, Mining & Metals

Each of the sectors may be further segmented into industries.  For instance, the Chemicals industry is a component of the Materials sector.  Subdividing sectors into industries offers investors an opportunity to fine tune their portfolio diversification in a more granular way.

Top 5 Dividend Champions Industries

Industry	Champions
Banks	19
Machinery	11
Insurance (tied)	8
Chemicals (tied)	8
Water Utilities	7

An interesting point when looking at the top sectors or industries within the Dividend Champions list is that technology firms aren’t found among the top 5 in either case.  Although there are technology companies within the Dividend Champions, they aren’t heavily represented. 

If you’re looking for a wide variety of trendy tech plays, you won’t find it in Dividend Champions land.  Instead, you’ll have to move forward with solid, consistent, dividend payers that don’t regularly make MSNBC or Cramer’s Mad Money, but would be worthy of Ben Graham, Warren Buffett, and value-investing Dividend Farmers.

The thoughts and opinions expressed here are those of the author, who is not a financial professional.  Opinions provided should not be considered investment advice.  They are presented for discussion and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.

Investment Diversification: Is more better?

Investment Egg Basket

As mentioned in the post 5.5. Reasons Dividend Stocks Beat Index Mutual Funds, the prospect of buying a huge basket of stocks in an index fund doesn’t really provide better risk mitigation than could be had with a compact basket of 20-30 stocks – probably even fewer.  In this case, the risk being discussed is that your invested funds disappear courtesy of an unforeseen business disaster on the part of the company in which you invested.  The general premise of this piece is laid out below.

Scenario #1:  Your money is invested entirely in Company A which has a 10% chance of going out of business for various reasons.  This means you have a 10% chance of losing your entire nest egg.

Scenario #2: You split your investment portfolio evenly across Companies A and B.  Both firms are in unrelated segments like transportation and health care in which case the probability of either entity going under is independent of the other doing likewise. 

The probability of Company A going out of business remains 10% as in the first scenario.  The probability of Company B going belly up is also 10%.  What now is the probability of completely losing your shirt because both companies tank at the same time?  The companies are in unrelated industries in which case the probability of one going out of business is independent of the probability of the other going out of business.  The probability of two unrelated events happening simultaneously is determined by multiplying the probably of A times the probability of B: 

Probability A (10% ) x Probability B (10%) or .10 x .10 = .01 or 1%.

By spreading your investment pool from one company to two companies in divergent industries you’ve reduced your risk of losing everything from 10% to 1%.

Scenario #3: You think to yourself that if investing in 2 companies reduces risk, then investing in 3 companies has to be better still.  (It is, to a very small degree.)  Therefore you spread your wealth across three companies (A, B, C) each with an independent probability of going out of business of 10% because they are all in unrelated industries.  Now the risk of losing your life savings is calculated by multiplying the risk of A x B x C shown here:

Probability A (10%) x Probability B (10%) x Probability C (10%) or .10 x .10 x .10 = .001 or one-tenth of one percent.

By spreading your investment pool from two companies to three you’ve reduced your risk by nine-tenths of one percent.  The risk reduction generated isn’t large but the added workload in monitoring the third firm is, relatively speaking.

Carry this math across 15 or 20 firms and you’ll see the risk reduction becomes excruciatingly small while the management workload increases greatly in proportion.   

The math means that an index fund with hundreds or thousands of companies held within it produces no meaningful risk below that of a small, selective portfolio of quality companies as far as I’m concerned.  It does, however, generate a lot of extra work OR management fees for the index mutual fund.  Brokers and money managers like that fact.  It works to their advantage when millions of investors aren’t paying attention.

Investopedia does a nice job summarizing investment risk.  Systemic or market risk which can’t be diversified away (think inflation) and unsystemic risk which is germane to a specific company.   The unsystemic risk is what diversification is designed to mitigate.  As you can see from the examples above, the law of diminishing returns is prominent rendering moot the advantage of holding hundreds or thousands of firms in a single fund and paying a fee for the privilege of doing so.

Andrew Carnegie once said “The way to become rich is to put all your eggs into one basked and then watch that basket.”  I’m not comfortable with that advice nor am I comfortable with the current wisdom endorsing investors to put a little money into every basket and watching none of it.  Let the pros watch it for you – for a fee.  With a little work and a few tools, it’s possible you can cultivate good ground somewhere in between.  You can concentrate on solid, dividend paying companies in a diversified portfolio of 20 to 30 holdings, maybe fewer, avoid annual fees, and succeed.  It’s worth investigating, right?

The thoughts and opinions expressed here are those of the author, who is not a financial professional, and therefore should not be considered as investment advice.  This information is presented for education and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.       

5.5 Reasons Dividend Payers Beat Index Mutual Funds & ETFs

Index?  Mutual?  Dividend CCC!

Over the past couple months I’ve covered a host of reasons I think investing in strong dividend paying companies is better than parking money in real estate, precious metals and collectibles, non-dividend stocks, annuities, and target date mutual funds.  Therefore, I thought I’d tackle the reasons dividend stock investing is superior to index mutual funds or ETFs.  I’ve had a lot of coffee today and it’s probably a good thing, so here we go.

1) Compound growth is more reliable with dividend stocks than it is with index mutual funds and ETFs in general.  When individually held dividend stocks pay out their dividends, those dividends turn directly into additional shares of the company, assuming you’re enrolled in a Dividend Reinvestment Plan (DRIP).  Many, but not all, index funds and ETFs will retain dividends paid, increasing the Net Asset Value (NAV) rather than turning those dividends into additional shares of the fund for you.  I hold a couple such index funds in a 529 plan for my kids and a 401k so I’m well aware of this fact.  I don’t have much choice in either case.  Otherwise, neither would be in my portfolio.  NAV can fluctuate up and down given the market movement of the stocks it holds, irrespective of dividend payments.  In comparison, directly held dividend payers don’t subtract shares from your bucket unless you sell them.

2) Management fees erode your returns.  When participating in the DRIPs of dividend paying companies, or automatically reinvesting dividends from stock held in your brokerage, you don’t suffer the penalty of management fees.  The same cannot be said of index funds or ETFs.  This is particularly true if you’ve blundered into a managed index or ETF in which case your fees can be as high as a half-percent per year.  That may not sound like much, but once your portfolio reaches $100,000, you’ll lose $500 every year.  Those losses add quickly, particularly when you factor in the power of compound growth foregone.

3) Visibility and manageability of your holdings is much better with a select portfolio of dividend payers.  An index fund or ETF attempts to hold the same companies, in the same proportion, as found in the index it tracks.  Consequently you could own thousands of firms, most of which you’ll care little about – if you know about them at all.  To find out what you own in an index fund you have to sort through multiple pages and potentially thousands of lines of the index fund prospectus to know what’s in your basket.  That’s too much for most amateurs to manage in which case you’ll pay fees for a manager.  Brokerages like this.  See item #2 regarding management fees.

4) Investment diversity is frequently argued as a simple, brilliant form of risk mitigation.  The financial industry has taken the argument to the nth degree by selling the proposition that a fund of hundreds or thousands of companies offers greater diversification i.e., less risk, than a smaller grouping of individually held dividend paying stocks.  But is this true?  I can get considerable diversity or risk mitigation with 20-30 holdings in a well-chosen selection of dividend payers.  Adding hundreds of additional companies doesn’t reduce my risk much beyond that smaller holding – particularly if all those holdings are wrapped in a single package delivered by one financial institution.  In a future post, I’ll take a brief look at the probability underpinning the maxim of investment diversification. 

An index fund allows you to hold many, many companies at once providing the touted investment diversification.  However, I would argue that a vast array of companies is not necessarily better.  Warren Buffett agrees.  Or better, I’m of the same opinion as Warren, who said “diversification is protection against ignorance. It makes little sense if you know what you are doing."  The theory is most investors don’t know a post hole from their pie hole and should buy a huge basket of everything to limit risk rather than learning something about a few things and sticking with what they actually know.  The argument is great for the croupier class taking tine pieces of considerable investment activity via small management fees tacked onto index funds and ETFs.

5) Selective quality with individually held dividend stocks is much great than it is with an index fund or ETF.  Consider the estate sale in which a box of unknown stuff is auctioned off with little or no inspection by the bidders.  Bidders are attempting to buy the box at the lowest possible price hoping they’ll find a diamond among the rubbish they know they’ll get otherwise.  When you buy an index fund or ETF, it’s the same principle.  You’re buying thousands of companies in one fell swoop hoping the handful of gems more than offset the dregs and millstones you’ll invariably get.  It's less risky to pick and choose what you're putting your money into than throwing it over the wall and hoping for the best.

5.5) Additional thoughts:  Advocates of index funds and ETFs argue that diversification for small investors is easier with an index fund than individually held stocks.  This is true if you have only a couple hundred bucks to invest.  Once your investment basket has climbed above a few thousand dollars, I’m not sure that argument still holds.

A second argument is that index funds allow people to invest in with little risk, but complete ignorance.  Investors don’t have to read, research, or even think to participate safely in the market, or so goes the story.  I’m not sure this is a stellar idea to propagate but it’s a thing none-the-less.  It's better to put in a bit of effort when participating than diving in completely unaware.  Contrary to the old axiom, ignorance is not always bliss, particularly when investing for your future.

The thoughts and opinions expressed here are those of the author, who is not a financial professional, and therefore should not be considered as investment advice.  This information is presented for education and entertainment purposes only.  For specific investment advice or assistance, please contact a registered investment advisor, licensed broker, or other financial professional.