Last Updated on April 26, 2022 by Rational thinking
Building a dividend portfolio requires some thinking and research. What is a good dividend portfolio?
A good dividend portfolio has a wide variety of stocks from different sectors and industries, has low debt levels, contains antifragile and recession-proof stocks, and is not high-yielding. In short, you want quality businesses in your dividend portfolio.
In economic terms, a portfolio is a set or collection of a person’s financial investments such as bonds, cash, stock, commodities, exchange-traded funds (ETFs), closed-end funds, and equivalents of cash. Although portfolios have gained the reputation of having bonds, stocks, and cash as the heart of a portfolio, it is not always the case. There could be a wide variety of assets like private investments, collectible arts, and real estate comprised in a portfolio.
Everyone has their own mindset about everything, it’s quite individualistic, and what comprises a good dividend portfolio is no exception. Generally, most debates that center around dividend portfolios talk about the number of stocks an investor should own and the diversification of those investments in various sectors.
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The importance of a dividend portfolio
One of the most important jobs a dividend portfolio aces at is diversifying risks. There is a reason why investors should build a dividend portfolio as opposed to complementary investing in one or two companies. The reason being, the entire concept of investing is influenced heavily by luck which interprets potential risks.
Imagine investing your entire cash into one company, which might result in lower risks but the returns will differ heavily from that of the markets. There are not many investors who can take on the risks that come with the volatility of the market, considering there are many possibilities that may result in significant loss of capital or even permanent loss.
On the contrary, if an investor buys shares of all the stocks in the market, his portfolio will diversify enough to weather some storms while their dividend income and investment returns won’t depend on just a single stock.
However, it’s pretty obvious to assume that it can be impossible for a person to invest in shares of every company listed without using exchange-traded funds. But it is easy to understand the benefits that come with investing in more than just a few companies.
Diversified portfolios help to moderate the risks away. While building a portfolio that translates to be a good dividend portfolio, it is important to the factors that influence the returns and volatility of the portfolio.
Factors influencing good dividend portfolios
There are mainly four factors with the most impact on the volatility of a portfolio’s return with respect to that of the market’s return.
Number of holdings in a dividend portfolio
Not every investor can have the resources nearly similar to that of Warren Buffet’s connections and insights to construct a highly focused portfolio.
For the very same reasons, it’s better to rather span your investments over a reasonable variety of stocks. But the question does come up, what is the decent amount of dividend-paying stocks an investor should own in order to increase benefits and maximize diversification? How many dividend stocks should you own?
The American Association of Individual Investors (AAII) says:
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 study continued to mention that diversifiable risk will be decreased by the below-mentioned amount:
Holding 25 stocks reduces diversifiable risk by approximately 80%
Holding 100 stocks reduces diversifiable risk by approximately 90%
Holding 400 stocks reduces diversifiable risk by approximately 95%
In a paper named Equity Portfolio Diversification: How Many Stocks are Enough? Evidence from Five Developed Markets by Francis Tapon and Vitali Alexeev, the outcome of this study in late 2014 suggested that during financial distress in markets, a much bigger number of stocks are required to diversify the risk. The researchers went on to conclude the average number of stocks to hold is 55, however, the numbers should increase to 110 in times of distress.
Apart from just focusing on the number of stocks to hold, an investor should also consider other factors that are more relative to their own financial stand like the size of their portfolio, the time they are willing to invest in research, trading costs, etc.
Diversification in stocks by owning a greater amount of stocks may reap a lot of benefits, but they may not be adequate.
Many investors make the mistake of badly diversifying stock by focusing on certain kinds of stocks that fall under similar sectors. That is the reason why having stocks in similar industries and characteristics may not provide enough diversification.
The reason behind such kind of diversification is that stocks that come under the same industry are easily influenced by the same factors. This simply means that stocks with the same characteristics are correlated and are sensitive to the same factors.
So for instance, if shared factors such as the price of oil or interest rate are suffering, an investor’s portfolio can heavily underperform the market. Hence, holding stocks in different sectors diversifies the risk on an industry level.
So when some of the sectors may be struggling, others will likely be performing well. Inevitably we will have recession or panic, and you must consider how much it can fall but more importantly how it will recover.
However, diversifying by sectors should not violate your comfort zone or fall outside of your circle of competence. For instance, many investors that are conservative try to not indulge in the technology sector as their pace changes pretty quickly. Thus, predicting where the tech companies will stand in another 5 years can become challenging for many investors.
The key takeaway from industry diversification is that while you should indulge in intentionally diversifying your stocks across various sectors and business models, it’s not compulsory to be involved everywhere. Play the areas according to your comfort and confidence while diversifying.
The credit quality of the holding refers to the debt a company may be in. This is one of the crucial factors when looking for safe stocks for investors. The debt of a company directly affects the fluctuations in the price of the stocks considering the business conditions. Companies with greater debt loads and recurrent business models can generally have volatile stocks.
So to say, if the interest rate were to rise strongly and the credit situations are tight, the firms that suffer in quality and are highly levered can fall into serious trouble. Checking the overall credit quality of your holdings is very crucial while building your dividend portfolio.
Is your company robust, antifragile or recession-proof?
High levels of debt might make companies fragile. Nassim Nicholas Taleb is famous for his book called Antifragile. This is a keyword you should always have in the back of your mind.
What does antifragile mean? It’s the opposite of fragile. Fragile things need to be handled with care, or else they might break. Antifragile companies thrive under volatility and stress – they get better.
Sin stocks, so-called unethical stocks like for example tobacco, alcohol, and brothels, have shown to be robust and resilient. They have stood the test of time and it seems there will always be a market for these products, even if they were outlawed (then of course you can’t own them on an exchange).
They are little exposed to disruption. Moreover, most of these stocks can be labeled as dividend stocks. They throw off a lot of cash which is distributed to shareholders.
Even if your company is not antifragile, you should look at how the stock performs in a recession. A 75% loss needs to gain 300% to break-even. How has the company performed in recessions? More important than the share price are the operational metrics and performance.
Don’t chase yield
Many dividend investors tend to chase yields. But research indicates the high-yield stocks have underperformed. It’s the yield in the quintiles 2-4 that have performed the best (not the lowest and the highest yielders).
Why is this? One reason could be a dramatic fall in the share price, and you must ask yourself why. Often it’s for good reason. Another reason could be high historical dividend growth that has risen higher than earnings, And in the end, it’s the earnings that produce the dividends.
This is why you should pick stocks that have moderate payout ratios, seldom above 70%, but preferably around 50%. Why? Because you need both dividend growth and capital appreciation.
Decades worth of data clearly shows that companies with smaller market caps have suffered price volatility in their stocks in comparison to the larger market cap stocks.
The concept is that there would be more buyers and sellers to trade the shares back and forth in a bigger company. This availability of buyers and sellers is what we call liquidity.
So for instance, if you want to buy or sell shares of any company, there has to be someone on the other side in order to consent to your asking price in order to execute the trade. In a situation where the availability of buyers and sellers is low, it won’t be easy to move in or out of positions.
In such an event, the price that a seller is asking for and the price that the buyer is willing to pay spreads very wide.
Thus, small companies can have comparatively low liquidity than large-cap companies. Depending on different market conditions, companies with less trading liquidity and small-cap stocks can majorly underperform or outperform large-cap stocks.
Moreover, stocks with small caps can be more volatile than the ones with large caps is because their businesses are far less diversified and sometimes have unproven business models.
All of the above-mentioned factors can majorly influence a portfolio’s performance particularly during the time when the market is in distress. The entire point of building a good portfolio is to diversify the risks and factors away, especially the ones we have no control over and can’t predict while keeping our focus on the performance of companies individually.
What is a good dividend portfolio – conclusion
Building a good dividend portfolio majorly depends on the individual investor’s objectives, goals, capital available, tolerance over risks, etc.
It is also important to remember that nothing is certain in this world. Understanding the risk factors that directly influence your portfolio returns and fluctuations can go a long way in reducing unnecessary risks.
Moreover, keeping in mind the factors that influence your dividend portfolio, you should reflect on your personal objectives and situations. Ask yourself questions like the reason behind why you are building a dividend portfolio? Are you reaching retirement and are hoping to create a steady amount of passive income to support you in your latter days to live off an easy life? Are you saving for your future generation to come? Why do you choose dividends above capital appreciation?
Moreover, apart from reviewing these factors, check your risk tolerance and your willingness to commit to staying regular with your portfolio.
All these questions will help you choose stocks that are safer. This will also benefit you in choosing the number of stocks and their characteristics individually based on price volatility, dividend safety scores, dividend yield, etc.
Lastly, even though we are talking about a dividend portfolio, a high dividend is never a reason to invest in a bad business. In the long run, the performance of the business is what ultimately drives a stock’s return, and the company’s ability to pay a dividend.
At the end of the day, a good dividend portfolio consists of quality businesses.