Last Updated on December 24, 2020 by Oddmund Groette
A sign of a strong portfolio is to construct one that grows with you. Investors tend to incline heavily towards dividends paying stocks, attracted by the compelling numbers. But it is not wise to think of dividends as a risk free form of income. Surely there are investors who claim that they can build dividend growth but the whole point of building a robust portfolio is to minimize risks especially those factors that investors have no control over. The importance of margin of safety cannot be underestimated.
Thus, your portfolio should not only have dividend stocks. You should also include compounders and perhaps one other asset class outside stocks. However, a specific percentage can only be determined by knowing your investment goals and risk tolerance.
It is also important to diversify your portfolio in more than just investing in one stock. You must diversify by sectors as well. Investing in stocks that are influenced by the same factors can be prone to unnecessary risks. Moreover, a dividend isn’t exactly income because it is simply a distribution of a shareholder’s equity in the company.
Nevertheless, this isn’t about demeaning dividends, it’s about creating the right set of asset allocation before realizing the off traits that come with dividends. Again it’s all part of diversifying the risks away when you plan on constructing a portfolio. If you are a dividend investor, make sure you understand all aspects of the pros and cons of dividend investing:
Asset allocation is known to be a form of investment strategy aiming to allocate assets in a portfolio with an aim to balance risk and manage the assets with respect to an individual’s goals, investment horizon, and risk tolerance. There are typically three main asset classes- fixed income, equities, real estate, cash, and its equivalents (these being the most relevant asset classes for most people). Each behaves differently with time and have their own levels of returns as well as risks.
Asset allocation in simple terms means spreading your investments in a mix of bonds, stocks, real estate, and cash or money market securities . Within these classes, there are subclasses – large, medium, small-cap stocks, international securities, emerging markets, fixed income securities, money market investments like Treasury bills, Real Estate Investment Trusts (REITs), etc.
While reducing risk, an investor aims to meet his desired level of return. In order to achieve that, an investor needs to understand the risk factors affecting the returns. For instance, treasury bills are known to have the lowest risks as they are backed by the U.S government but on a downside, they offer the lowest return. As of writing, they offer a paltry 0.8% return.
That’s why asset allocation is respective to an individual investor’s risk tolerance, aim, time horizon. Every asset has its own ups and downs or what we call market fluctuations. Thus, diversification based on different assets makes sure that if your more volatile assets are suffering, then the stable ones can balance out the total returns.
While a certain percent of your portfolio should be dedicated to dividend-paying stocks, the remaining should be allocated to other assets, which are more flexible and efficient than dividends.
Why investors are mistaken to call dividends an income is because a dividend is just a distribution of an investor’s equity in the company. Equity is the assets that the shareholders receive in a case where the company is liquidated. Since dividends are paid from the shareholder’s equity, it results in decreasing the assets of the business.
Capital is transferred from the company right back to the shareholder’s account. Stocks are found to drop the same amount as the dividend as it goes ex. dividend because of this very reason. Thus, experts say that a dividend is basically a partial liquidation of the company because it is technically a transfer of capital.
Moreover, many investors take on the misconception of confusing dividends with coupons. Considering dividends as an income is not exactly smart and there are further disadvantages to them than what first meets the eye –
- Dividends are not guaranteed
- Investors have no control over dividends
- Dividends come with tax disadvantages
- Not enough risk diversification
- Distract from total returns
While receiving a dividend, it is not compulsory that your net worth will be higher than before, in fact, it could be lower if you are in a tax position. So instead of focusing too much on what you can transfer from your investment account to your cash account, try to compound effectively.
Compounding takes you towards investing further into a company’s growth and further increasing your return. Dividend payments for many tend to take the focus off the more important things like growth, maturity, and earnings. Moreover, a company that is capable of redeploying earnings is much a better alternative and beneficial than a dividend payer.
An optimal portfolio is personalized to each investor’s goals and risk tolerance. Thus, while considering every asset class with its own level of return and associated risks ( like I mentioned before), an investor needs to speculate their own risk tolerance, objectives of investment, time horizon, money availability to invest as the grounds on which they allocate their assets.
Those investors who have a longer time horizon and a good amount of money to invest tend to feel comfortable with high-risk options with high returns potential. On the other hand, investors with a shorter span of time might incline towards less risky with low return assets.
Based on risk tolerance and in order to make the process of risk allocation easier, many investment companies are known to come up with a series of model portfolios. These model portfolios comprise different proportions of different asset classes satisfying a focused level of investor risk tolerance. These model portfolios go from conservative, moderately conservative, moderately aggressive, aggressive to very aggressive.
Following these model portfolios can help inventors set their priorities based on their personalized goals and requirements.
A smart investor should analyze and allocate the significance of the percentage of an asset in their portfolio strongly based on estimating total earnings and opportunity costs instead of picking just dividends with attractive yields. Moreover, the best thing to do is to keep an open mind and be flexible while allocating assets in your portfolio for improved investment results.
Apart from the technical aspects of diversifying based on different markets and sectors, it is important to ponder on your own comfort zone of knowledge and tolerance for risk in order to meet your goals for investing in the first place.
Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinion – they are not suggestions to buy or sell any securities.