It’s well understood that you need some level of diversification to hedge investments in your portfolio. But how much diversification is too much?
My portfolio is pretty well hedged. I have a variety of large and small businesses, across a variety of industries that are collectively working to crank out my dividend income. I could be doing a better job with my diversification though. I discovered recently that I was light on healthcare stocks, which I’ve subsequently looked to correct. Consumer staples is another category that I wanted to further expand.
That being said, I’m generally pretty comfortable with my overall level of diversification. However, I’m always looking to add additional high quality dividend income stocks where I can find them. That raised the question in my mind.
Should there be a natural limit to the number of dividend stocks that I look to have in my dividend machine, and if so what should that limit be?
Reasons for more diversification
Eliminate “systemic” stock risk
One of the big benefits that come with diversification is reducing or minimizing stock specific risk. The beauty of diversifying is that you progressively reduce the impact of a devastating, stock specific event on your portfolio. Based on some of the material that I’ve read, the ownership of about 20 stocks will get you almost 90% of the diversification benefits of an index fund.
Beyond that, the relative benefit that you get as far as diversifying stock specific risk reduces, and you’ve done what you need to do as far as minimizing the effects of a catastrophic event on your portfolio.
Reduce quantum of Individual exposure
In my view, the biggest reason that you want to keep adding more stocks to the portfolio is the individual exposure you have to a business steadily increases over time with asset and business growth. Your $10k investment in McDonalds 10 years ago would be worth almost $80k today. If things continue on such a pace, an investor could be looking at a holding of hundreds of thousands of dollars in a McDonalds holding.
While I don’t think McDonalds is going anywhere anytime soon, a discovery of something bad in those french fries could decimate an investment in the stock and have huge portfolio implications. As your portfolio increases in size, having many more positions to spread across the risk is going to be a natural consequence of not wanting to be hung out to try by any one failure. In a $1M portfolio, even if you only have 50 equal positions, that’s still an exposure of close to $20k a position.
Reasons for less diversification
Tracking 50 companies!
Thinking suggests that it’s hard for an individual to be on top of and track details of more than 20-30 companies. I think this one is going to be dependent on an individuals aptitude to be on top of and understand many different businesses, and also how complex those businesses happen to be.
If I had to be on top of 50 businesses that were as complex as CME group, I’d probably lose my mind. The simplicity of something like a Coca Cola or a McDonalds or Colgate is that they are pretty transparent and easy to understand. I think I could fairly easily manage 30 or more of these types of investments fairly comfortably.
Watering down your return performance
As you continue adding additional positions to your portfolio, you eventually get closer and closer to performing like the market. Over time, you may find that your returns actually look more like an index fund, which begs the question of why anyone would go to the trouble of compliling so many positions anyway, if you could effectively transact cheaper , and get the same returns, by investing in an index fund. This argument doesn’t concern me much.
The reason is that I’m not necessarily looking to build up a portfolio to outperform an index. I’m buying to build up a portfolio to generate a high quality income stream. If in the process I happen to beat a benchmark, then great. If I don’t, so be it.
My experience thus far happens to be that my dividend investing beats the index, but if I was to underperform over a period of time, it wouldn’t concern me in the least, because my dividend income would still flow through.
Diluting the quality of your income stream
This is of great importance to me, and it’s a legitimate concern with holding too many positions. There are only some many companies to go around with high quality businesses models, sustainable franchises and defensible competitive positions. It’s not everyday that you have the opportunity to invest in companies like McDonald’s and Coca Cola that have been paying dividends and growing for years. That have solid brand recognition and generate strong consumer demand.
Sure, there are a bunch of other companies that are paying dividends, but the dividends may be newly introduced, or based on cyclical, unsustainable earnings. Frankly, they could just be smaller companies where there is not necessarily any great track record of success.
This starts to open your dividend machine up to the risks of uncertainty around dividend payments. Will those dividends be maintained? Are there possibilities of dividend cuts? How do I know that I can count on this dividend stream years into the future.
For me, this is the point where I know I’ve added too many companies to my portfolio. The point where the next company that I invest in raises a question in my mind of whether a dividend will exist in 10 years time is where I know I’ve added one company too many.
Certainly smaller companies carry elevated risk, but the smaller dividend paying companies that I have added into my portfolio have been included because I believe that they have a moat and barriers to entry that will mean they can continue paying the dividend for the forseeable future.
Diversification in a portfolio is super important in my view. It helps me avoid the risk that a stock specific event destroys my dividend income stream.
Is it possible to over diversify? Potentially, if you start adding positions that get you into a less and less secure stream of dividend income. Otherwise if you have investments in fairly transparent business models with simple business drivers then I don’t believe there is any real danger of “overdiversifying”.