At the top of the list of dividend growth investing benefits many a seasoned investor will rank the principle of income diversification through a basket of stocks that throws off dividends. Rightly so, it’s better to receive ten small paychecks worth €1,000 in total rather than one big cheque worth exactly the same amount. Even though it’s easy to diversify your income sources with dividend stocks, only few investors actively pay attention to it.
Today, I’d like to rectify that.
I’ve noticed that “diversification” and “diversify your portfolio!” currently amount to nothing more than catchy phrases that hardly anyone actually pays attention to. With myself being one of the culprits, it’s high time that we take a closer look at what it means for a dividend growth investor to diversify his investments, especially with regards to the future passive income that his portfolio generates.
Diversification in a financial context means the reduction of non-systematic risk by investing in a variety of assets in such a way that there’s no positive relationship among the return of those assets. Of course, this almost academic description has been popularised by the proverb “don’t put all your eggs in one basket”, which is what most people understand by diversification.
As such, many investors try to diversify the weight of their portfolio’s holdings based on a number of criteria, among which geographical and industry categorisation are probably the most popular. While that’s a good thing in and of itself, Keith from DivHut recently made me see the light in one of his comments.
Ask yourself the following question. Which type of diversification is by far the most important to a dividend growth investor?
To me there’s two basic ways to reduce the systematic risk of your dividend portfolio. On the one hand you can diversify your portfolio through weighted averages like almost every other investor does, but on the other there’s your dividend income that should also be diversified. It’s this last type of diversification that’s often forgotten by our community because it’s rather unique to dividend growth investing.
Let’s take a look at my own dividend portfolio.
The graph below shows the weight of ten industries in my portfolio in blue, as I’ve added them to my dividend stocks tracking sheet. The orange bars display my forward dividend income at the moment for every indsutry. As you can see, there’s quite a lot of difference between the two.
Where defensive consumer goods make up the bulk of my portfolio value, they come in only second with regards to generating passive income. The opposite is true for energy companies. While their weight sits at a comfortable 14% of the total portfolio, the income they generate amounts to 22% of my estimated annual dividends. That’s a big difference!
The diversification between regions is even more pronounced with regards to Europe and Switzerland. Even though the difference between portfolio weight and dividend income is partly due to foreign withholding taxes, much can be attributed to energy stocks as my European portfolio contains quite a lot of them. On top of that, my two European financial stocks offer some of the best yields.
Even though this chart seems to confirm what many investors have experienced for decades, namely that European companies generally offer a higher yield, that’s not what I take away from this small exercise. To me, it’s clear that I have to pay more attention to the diversification of my dividend income rather than the weight of the individual stocks in my portfolio.
Energy stocks may not seem to be overweight at first glance, but when drilling down deeper into the data it becomes clear that almost 25% of my yearly income can be attributed to them. That’s simply too much for my taste, something I discovered after recently buying more Royal Dutch Shell (AMS:RDSB). When you try to diversify across ten industries you’re not doing a good job when one of those industries provides 25% of the yield.
Imagine what would happen if oil continued its price decline, leading the energy stocks in my portfolio to cut dividends? That’s 25% of my forward income at risk even though these stocks only make up a little less than 15% of my invested assets.
Of course, you can ask yourself “where do I draw the line?”
What’s too much yield for a single industry or region? The answer isn’t immediately clear and is contingent on the personal preferences of investors. On top of that, there’s external factors outside of your control such as the previously mentioned withholding taxes, but also the historically higher yields of energy stocks, utilities and real estate investment trusts.
All of these stock characteristics play a role in the portfolio and dividend diversification of your investments, which makes achieving a perfect balance between sectors, regions, currencies, and a whole myriad of other things a gargantuan task if your portfolio continues to grow.
Still, I believe it paramount that we as dividend growth investors consider the implications of an investment on our future income. Before looking at complicated solutions to systematic portfolio risks like hedging, we best employ easier strategies like dividend income diversification. If we don’t, we effectively render the often praised benefit of multiple income sources void.
Have you dealt with the issue of dividend income diversification in the past? If so, how did you tackle it?