Diversification is a way to reduce risk by adding variety to a portfolio. Assuming individual stocks are not perfectly correlated, the positive returns of some stocks should offset the negative returns of others. According to Investopedia, studies have shown that "maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective level of risk reduction". Increasing the number of holdings beyond 25 to 30 stocks will reduce risk further, but at a diminishing rate.
Risk cannot be eliminated entirely through diversification. Some risk is systemic and affects nearly every stock. Example causes are inflation, interest rates, political unrest, and war. For this reason, it is a good idea not only to diversify within a portfolio, but also to diversify across different asset classes.
Consider the following graph, which plots the performance of the S&P 500 and the Dow Jones Industrial (DJI) Average over a 5-year period between June 1, 2009 and May 27, 2014. The S&P 500 increased by about 100%, while the DJI Average increased by about 90%. The trend is generally UP.
|
When I look at a graph like this, I wonder if the trend would continue or abruptly change course. Although the market can go up for longer than you could imagine it would, it could also turn on a dime.
Not long ago, we experienced a similar 5-year period of growth. The following graph plots the performance of the S&P 500 and the Dow Jones Industrial (DJI) Average over the 5-year period between October 7, 2002 and October 8, 2007.
 |
Again, the trend is generally UP (although the average slope is not as steep as in the first graph).
Now, we know what happened in the period between these two graphs: the Global Financial Crisis of 2007-2008, considered by many as the worst financial crisis since the Great Depression of the 1930's. Large financial institutions collapsed, banks had to be bailed out by national governments and stock markets around the world tanked. Total losses due to the crisis are estimated to be in the trillions of U.S. dollars globally.
|
Looking at the graph above, it is clear that panic-selling during the crisis period turned out to be the wrong thing to do. Many investors lost a significant portion of their wealth in the process.
Of course, dividend growth investors have a different objective. We invest for the long term. We invest in companies that pay dividends and increase those dividends over time, even in times of crisis.
I started DivGro in 2013 and have grown the portfolio to nearly 6 figures in 17 months. Besides DivGro, I have other portfolios with different objectives. They have served me very well, but I've slowly scaled them down as my investments in DivGro increased.
This month, I sold most of the holdings in my other portfolios. I'm only keeping the best of the best.
The reason is diversification: I'm moving more of our net worth into real estate. We're buying a second house and turning our current house into a rental property! This is an exciting, but somewhat scary time for us...
Thanks for reading! Please feel free to comment below...
Very good article on diversification. I can't wait to get up to 25 stocks in my portfolio to decrease the risk. Right now I have 6 but I am on the lookout for a new stock for June. Did you invest in income properties? I plan on doing so next year in order to increase my monthly income. Thanks for the post!
ReplyDeletehttp://dividendmongrel.blogspot.com
We're not investing in income properties, but we're buying a second house and planning to keep our current house as a rental property. We still owe money on the mortgage loan of our current house, but after refinancing and given the hot rental market in our region, I believe we can practically break even. Effectively, retaining our current house will not generate income, but as a long-term investment it should be a great inflation hedge.
DeleteBuying a second house is indeed a big change! Don't underestimate the time involved with renting out property, it can be quite timeconsuming to a) find tennants and b) make sure the house stays in good shape. Are you planning on doing that all yourself, or will you use an agency to take care of that?
ReplyDeleteBest,
DW
Agreed. I have a full-time job that keeps me busy enough, so I have no interest in being a property manager. We'll be using a rental property manager.
DeleteTake care!
Good post, DivGro. And congrats on making the decision to buy a second home. I wish you the best in your house hunt. I agree that this would be a good time to sell and exit the stock market. I am doing the same - and we just bought out first home :)
ReplyDeleteregards
R2R
Thanks Roadmap2Retire and congratulations on being a first time home owner! Actually, we've already bought our second house -- we're just waiting for escrow to close. That's why I've been somewhat quiet on DivGro lately... SO MUCH paperwork to complete!
DeleteTo be clear, I'm not exiting the stock market entirely -- just scaling down (significantly) my non-DGI portfolios.
Cheers!
Totally agree with diversification as I hold 55 stocks currently. Also agree on asset classes as I own aprox 40% of my investments in a commercial real estate space. I treat my real estate as fixed income investment. It provides me steady reliable returns and it yields above current bonds and GICs at a rate of 4.3% yield. As long as people not put all their eggs in one basket they will be well sheltered on another market crash as long as they do not panic and sell their equity portfolio.
ReplyDeleteWould be interested to know what your real estate plans and potential yield info and the % real estate to market equity mix you have.
Good Day and Grind On!
Asset-Grinder, 55 stocks is excellent diversification, as long as those are spread nicely amongst sectors, industries, and local/foreign.
DeleteTreating your real estate as a fixed income investment in which you're considering the yield prospects, of course is the right way to go about it. I have not done that, yet, and will probably not be doing so in the foreseeable future, either.
As mentioned elsewhere, we still owe money on our current house and we'll probably end up a couple hundred dollars short per month (when taking property taxes into account). Nevertheless, I think the inflation hedge in real estate will be worth that.
Someone pointed out that we could have taken the available funds to pay off the mortgage loan, instead of using it for a deposit on a new house. This is a good point, of course. For me, though, the discipline associated with a (very) tight budget is a good thing.
DivGro, I wish you the best with your new home and house rental. Just like Dividend & Whisky stated, it can be very time consuming. I owned a rental home 8 years ago and it was a total disaster. They owed 5 months in back rent on top of trashing the place. I never ended up finding them or getting the funds. Make sure to always check in on your renters.
ReplyDeleteHi TheStockFox -- I'm sorry to hear of your bad experience with renters. Its a pity that people act like that with property that is not theirs. I sure hope I don't have to deal with that!
DeleteMy retired parents own rental properties, which essentially serve as their "pensions". They have mixed experiences with renters. Some are wonderful, long-term renters who even improve the property while they live their (landscaping, etc.). Others trash the place and leave utility bills behind that my parents have to fight to get paid.
What I've learned from them is to follow-up on references and, if in doubt, to err on the side of safety. Your advice on checking in on the renters is good, also.
Cheers!
Owning apartments as investments is very popular. But I am not sure at all whether or not I want to do the same. Taking care of apartments could very well be too much work and I am not sure of whether using an agent to take care of the apartments would make it much better... I would then have to look after the agency - are they doing their job? And have all things that are required by law been done correctly? Using an agent wouldn't free you of the responsibility to make sure that everything has been done in respect to the law.
ReplyDeleteAnd the agency cannot solve the problem of tenants not paying the rent - if they'll not pay, they'll not pay, and you are going to lose money in the process even if you would eventually get the rent.
I am considering making my investments into real estate properties by using exchange-traded funds. I cannot imagine an easier way to do it than that. I would accept slightly lower returns for the greatly reduced hassle.
Thanks for stopping by and sharing your perspective!
DeleteYou're highlighting many of the challenges of owning rental real estate. In my view, the major hurdle is the initial capital outlay, which many just cannot afford. ETF's provide a decent enough alternative.
For me, the major benefit of owning real estate (generally, whether for rental purposes or not) is the built-in inflation hedge. Over a long term (many years), real estate tracks inflation very well. Also, if rental income can pay the mortgage, you're essentially benefitting in a leveraged way -- by gaining the inflation-tracking benefit on the portion of the property that you don't yet own. ETF's can't deliver that.
Cheers!