The Money Tree

Safely Generating Income in Retirement

“Dividend House” – Lack of Diversification – A Rebuttal

Posted by mounddweller on March 1, 2018

Fellow Investors,

I received a comment on my recent post entitled Building a “Dividend House”.  The commentor took issue with the lack of sector diversification in the selections I had made for the foundation of a dividend growth and income (DGI) portfolio.  Specifically, he took issue with what he saw as an overweighting in the Consumer Goods sector and a lack of any positions in the Information Technology (IT) and Financial sectors.  The purpose of this post is to provide a rebuttal and explain why I feel diversification should not be an overriding concern in this type of portfolio.

First, let us recall the objective of the “Dividend House” portfolio.  The overall goal of the portfolio is to provide a safe and growing stream of income in retirement. A dividend king stock, regardless of its sector or industry has proven to be resilient in all kinds of markets and economic conditions. That is why they make great candidates for forming the foundation of a portfolio.  As long as you can reasonably expect its business model to continue to be successful and its growth to exceed the rate of inflation nothing else should really matter.

Now let us look more closely at the sectors and industries of the stocks I chose to include in the foundation portion of the “Dividend House” portfolio.

As shown above the stocks selected for the foundation of the “Dividend House” portfolio, despite diversification not being an objective, are spread across 5 different sectors and 9 different industries.  Why did I not select any stocks from the IT sector?  Simple, there are no dividend king stocks in that sector.  Why no financial stocks?  Well, of the 27 stocks classified as Dividend Kings, there are only 3 in the Finance sector, two banks and one insurance company.  They are Cincinnati Financial, Commerce Bancshares, and Farmer’s and Merchant’s Bank.  Their 10-year annualized dividend growth rates are respectively, 2.82%, 4.35%, and 2.72%.  Compare those rates to the 16.25% average dividend growth rate of the 10 selected stocks and it is easy to see why they weren’t chosen.  Choosing one of them simply for the purpose of diversification would have resulted in a higher probability of mediocre returns in the future.

There is one other rule you ought to keep in mind and that is to concentrate, and not only in the Zen sense. Sweet are the uses of diversity, but only if you want to end up in the middle of an average” Adam Smith, the Money Game 1968

If you can identify six wonderful businesses, that is all the diversification you need. And you will make a lot of money. And I can guarantee that going into a seventh one instead of putting more money into your first one is gotta be a terrible mistake. Very few people have gotten rich on their seventh best idea. But a lot of people have gotten rich with their best idea. So I would say for anyone working with normal capital who really knows the businesses they have gone into, six is plenty, and I probably have half of what I like best. I don‘t diversify personally. ” Warren Buffett

Now, one final point with regard to my rebuttal on the lack of diversification in the foundation of the “Dividend House” portfolio.  The total portfolio does not consist of just these 10 foundational stocks.  Readers of my original post will recall that the “Dividend House” will also have walls, a roof, and even a garden.  Perhaps the best stocks for these parts of the “Dividend House”, will include positions from the IT and Financial sectors, or perhaps not.  Like the foundation, those sections will include stocks that offer the best opportunity for high, safe dividend growth.

 

Best Regards,

Troy

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