Keeping a diversified stock portfolio is a very important part of dividend investing. I remember when I first learned about this topic in college.
In school, they teach you formulas to determine portfolio allocations and weightings. However, personal finance is rarely so rigid and black and white.
You don’t want to put all your eggs in one basket. On the other hand, you don’t want to spread out your positions too thin.
Portfolio diversification is an art and should be tailored to your personal financial situation.
Why is portfolio diversification needed?
Portfolio diversification is a very important part of building a passive income dividend portfolio.
A well diversified portfolio will help you from going under when the markets tank during a recession. It is also a way to mitigate risk. If you put all your eggs in one basket and that stock goes down the gutter, tough luck!
Diversification needs a healthy balance. If you diversify too much, your portfolio returns will actually decline.
What determines portfolio diversification?
Here are a few things that should factor into your level of portfolio diversification:
1. Age: The younger you are, the more risk you should take. The older you are, the less risk you should take. A young 22 year old investor right out of college can put a significant amount of his/her portfolio into a few stocks.
In contrast, it would be unwise for an older investor to put so much concentration into a few stocks. If things go the wrong way, decades of saving and investing could be wiped out!
2. Living expenses and obligations: The higher your living expenses and the more obligations you have, the more diversification you should have. If you have a big mortgage, multiple kids, and a spouse, you probably shouldn’t be investing in just 5 stocks!
3. Tolerance of risk: Tolerance of risk is entirely subjective. It’s like saying what is your pain threshold! That being said, everyone has a certain tolerance of risk. That’s up to you to figure it out.
Could you be okay with losing 5% of your portfolio over night? If not, you probably need to diversify more.
Here are portfolio diversification rules that you should consider:
1. Can I sleep at night?
The easiest way to determine if you have too much portfolio concentration is the sleep trick! Yep, you heard me!
If you can sleep soundly at night, your portfolio allocation is just fine.
However, if you can’t sleep at night or if you’re thinking about one stock all day, you need to reduce that position ASAP. No amount of your sanity is worth gaining money for.
And yes, I do sleep like a baby at night!
2. Diversification is an art
Unlike what business schools try to teach you, portfolio diversification is not some formula.
In general, you don’t want to have too small positions on your portfolio. What’s the point in having a 0.2% allocation? You would be better with an index at that point. Even if the stock increases 10x, it will not have a noticeable impact on your portfolio!
At the other end of the spectrum, you don’t want to own 15%+ in one stock only to have it all 50%. In that case, your portfolio just declined 7.5%!
Diversification is an art. It is a constant juggling act. What you may consider properly diversified at age 25 might have a totally different meaning at age 35!
3. Largest positions should be ones you like most
Put your money where your mouth is! In general, I think your largest positions in the portfolio should be the ones that you like the most.
And by “like” I mean have the most favorable risk/reward profile.
While you shouldn’t overload your favorite positions in the portfolio, keeping some larger ones is a smart idea.
4. Rebalance by buying not selling
Portfolio rebalancing is really important. Think of it like tending to a garden.
Dividend investing isn’t “buy and forget investing.” I would highly recommend checking your portfolio allocations once a quarter to see how everything is performing.
The most common way to rebalance a portfolio is to sell shares in one position to buy shares in another. That’s fine and everything, but it’s not always the most efficient way to go about it.
When you sell shares, you pay taxes, which disrupts the power of compound interest.
Sometimes a better way to go about portfolio rebalancing is to buy shares in other stocks to reduce the position size of your larger holdings.
The result ends up being the same…except you don’t sell anything and don’t have to pay taxes!
5. Cash should be an important consideration
Many people don’t consider cash to be part of their portfolio. After all, cash earns nothing!
However, cash is one of the most underrated investments of all time. Cash represents dry powder.
When stocks crash or when the market goes into a recession, most people wish they had some extra cash on hand to buy great companies!
Fear is just another word for opportunity!
I’ve learned that no one should be 100% invested in the market at all times. Sometimes it’s very smart to put some cash in a high yield savings account and wait for opportunities to come knocking.
Great portfolio diversification isn’t some rigid mathematical formula. It’s always changing and should be flexible enough to suit your lifestyle and needs.
Readers, do any one of you also have tips on portfolio diversification? Let me know in the comments below!