The Rule Of 40 – Keeping Diversification In Focus


Co-produced with Treading Softly

Here at High Dividend Opportunities, we enjoy investing as much as the next person. What we do have, that many do not, is a set-out philosophy with some rules built in. These rules work as guardrails to keep us on track and prevent us from flying off the roadway of success.

One of these rules is called the Rule of 40. I considered calling it the Rule of 42 since that’s the answer to life, the universe, and everything, but I was never able to find the right question. If I did, you wouldn’t be reading this as the universe would’ve begun all over again.

When it comes to diversification, some investors feel a little goes a long way. It truly does – a portfolio of two stocks has a vast improvement over just one. As you continue to add securities to your portfolio, you can spread out and reduce your risk. We landed on 40 due to it being very near, if not the sweet spot between benefiting from diversification, and the loss of noticeable benefit beyond that amount.

Having good diversification is more than just the number of investments, and it does not mean owning hundreds of stocks. As you can see from the chart above, as you add more securities to your portfolio, the benefit of it drops. Once you reach about 50 securities, it would take a doubling of your portfolio to 100 securities before a measurable additional benefit occurs. The added benefit of just one is lowered until it takes nearly 50 or 900 more for any real benefit to be seen. Clearly, a portfolio of 40 to 80 stocks and bonds would be ideal. Diversification can only reduce certain risks. Investing primarily in the US market means an investor must accept a level of “market risk” that you cannot reduce unless you start adding international securities to your portfolio. This, however, exposes you to international risks that come from global macroeconomics and geo-politics to a larger degree.

Benefits of Diversification

Diversification provides protection and assistance to investors and retirees. You probably have long heard of the saying “don’t put all your eggs in one basket!” This works with investing as well. As a retiree or income investor, you must seek out reliable income from many avenues in the stock market. This way an unforeseen event from any single holding will not sink the ship.

This earnings season we have seen many companies post extremely positive earnings. Atlantica Sustainable Infrastructure (AY) and Enviva Partners (EVA) both raised their payouts. They yield 5.6% and 7.2%, respectively. Meanwhile, other securities are facing headwinds from COVID-19. Diversification mutes the impact of any negative events by offsetting them with positive ones.

Occasionally an investor will choose to overweight a specific security they have extreme convictions in or see as extremely undervalued. By aiming to keep each security between 2% and 3% of your portfolio, you have room for a few overweight holdings when you keep at least 40 holdings in your portfolio. This means going to 5% on a single one will not cause Titanic-level damage if it goes south.

Do you remember the Titanic? It was a ship engineered to be able to take some damage and keep on trucking… or sailing! However, the arrogance of the ship’s owners, lack of preparedness, and in the end damage it did receive caused it to not only sink but take hundreds of lives with it.

Building a portfolio to withstand the storms of life means understanding even a portfolio of the most reliable and sturdy securities will take hits along the way. COVID-19 is an example of a black swan event. Unforeseeable were its initial impacts on your portfolio, yet diversification by design allows your portfolio to keep moving forward.

Diversify Out of a Single Sector

One of the biggest mistakes made by new investors or retirees just taking over their portfolio is believing that diversification is simply holding a bunch of securities and never checking on their allocation to different sectors.

ChartData by YCharts

During this year various sectors have performed differently and some sectors like energy have seen sector-specific risks that have impacted its performance relative to the overall market. Many utilities have performed strongly while REITs have been strongly impacted negatively.

Consider this for a moment. You decide to diversify your pantry. So you go out and buy 40 different types of canned tomatoes – diced, chopped, whole, pureed and the list goes on. Now you want to make a meal or a salad, but all you have are tomatoes!

Investors make the same mistake. They compare their portfolio to the market indexes yet they are allocated to only a sub-sector of it.

Diversification requires that you break forth from the idea that one sector alone will carry you to success. You are not truly diversified if you only own REITs, for example. Those are nice tomatoes – like all kinds of them too! In the end, you can’t turn your tomatoes into a steak.

Diversify Between Security Types

Diversification also means keeping multiple types of securities in your portfolio. Common equity, preferred securities, and bonds all deserve a home in a highly-diversified portfolio. These types of securities perform differently in various market conditions.

ChartData by YCharts

Through this year, bonds have outperformed both the market in general and preferred securities. However, usually common equity has the greatest total return potential. As an investor looks to income investing or retirement, and their attention turns to reliable dividend income, preferred securities and bonds have a higher level of safety to their dividends by being higher in the capital stack or having cumulative dividends.

The classic rule of thumb is a 60/40 split between common equity and bonds, or common equity and fixed-income (preferreds and bonds). While this works in many situations, investors may adjust their portfolio in seasons of strong earnings and performance toward more common equity which may see growing dividends vs. fixed income. Likewise, when the market becomes turbulent and risks grow, accumulating a larger overall fixed-income position is wise.

Also note that while some sectors can go out of favor and underperform in one period, this can present a great buying opportunity to add more. This is exactly the situation today with property REITs (VNQ) and preferred stocks (FFC) (HPI) (JPS). These are two sectors that we are bullish on and provide a great entry point for income investors.

Conclusion

The Rule of 40 provides a quick and easy reference to determine how well you are doing with diversification. Maintaining an average individual position size of 2-3% will help keep you aimed toward your goal. In these 40 positions, you should keep exposure to various sectors found within the market and various types of securities.

Investors and retirees who want to do it alone should consult various resources to help them determine the allocations to sectors that they desire, and adjust them as needed. Members of High Dividend Opportunities routinely get updated with our target sector allocations and target goals of common equity vs. fixed income to make their investment lives as easy as possible.

The goal should be to have a healthy and proper level of diversification. This should be achieved through careful research, meticulous planning, and strong convictions. Throwing any old security into your portfolio in the name of diversification will lead to weakening your portfolio. Keep your portfolio afloat in the sea of life and be prepared for anything.

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Disclosure: I am/we are long AY, FFC HPI JPS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Treading Softly, Beyond Saving, Trapping Value, PendragonY, Preferred Stock Trader, and Long Player all are supporting contributors for High Dividend Opportunities.

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