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The Closest Thing to a Free Lunch

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Proper diversification is about the closest thing to a "free lunch" available to ordinary investors. When done right, it can buttress your overall portfolio from a company's catastrophic failure without significantly impacting your total long run returns.

It's an important tool for your investing arsenal, simply because none of us have perfect foresight as to what the market -- or any company in the market -- will do. Since we're all pretty much guaranteed to be wrong from time to time, it's critically important to have a way to assure that one incorrect move won't sink your entire portfolio.

How to make it work
Central to the concept of diversification is the need to own stocks that operate in different industries. That way, if one company you own fails, it's far less likely to take down the rest of your portfolio along with it. That's important -- but just blindly buying stocks because they're in different industries isn't enough. After all, they could all be duds. And the more duds you own, the lower your overall performance will be.

So in addition, it's also important that the stocks you buy are ones you have a reason to believe are worth owning on their own. That way, you're not risking di-worse-ification by buying clearly bad stocks just for the sake of diversifying.

Benjamin Graham -- the father of value investing and the man who taught investing to Warren Buffett -- likened this combination to playing roulette, only as the casino rather than the gambler. The occasional spin may go against the casino, but over time, the house generally wins.

So what stocks are worth owning?
The toughest part is figuring out which stocks are worth owning. In hindsight, it's fairly straightforward to look back and say "wow, I wish I had bought that stock 20 years ago." Unfortunately, we don't have the benefit of investing by hindsight, so we have to project the future based on what we know, today.

And over time, one metric that tends to be a decent harbinger of future returns is how well a company's management treats its shareholders. If a company makes both paying and regularly raising its dividend a priority, chances are good that it is structuring its business to be financially sound enough to support that priority for the long run. And in fact, there's good reason to believe that over the long run, such companies can actually outperform the broader market.

Fortunately, solid dividend paying and growing companies can be found across multiple industries. That makes it fairly straightforward to diversify while buying stock in companies that all share that same long-term investor-focused characteristic. The table below shows what would have happened if 20 years ago, you had bought a diversified handful of companies with some of the longest streaks of consecutive annual dividend increases in their respective industries:

Company

Industry

Consecutive Years of Dividend Increases

$1,000 Invested 20 Years Ago Became

Annualized Return

Diebold (NYSE: DBD  ) Business Equipment

58

$7,115.01

10.31%

3M (NYSE: MMM  ) Conglomerate

53

$7,501.60

10.60%

Coca-Cola (NYSE: KO  ) Beverages-Non-alcoholic

49

$7,275.46

10.43%

Stanley Black & Decker Tools/Security Products

44

$10,064.22

12.24%

Target (NYSE: TGT  ) Retail-Discount

43

$10,374.22

12.41%

Universal Corp (NYSE: UVV  ) Tobacco

40

$8,758.76

11.46%

Abbott Laboratories (NYSE: ABT  ) Drug Manufacturers

39

$6,870.03

10.12%

Nucor (NYSE: NUE  ) Steel & Iron

38

$12,678.57

13.54%

WGL Holdings Utility-Gas

35

$6,808.24

10.07%

Totals    

$77,446.11

11.36%

Source: DripInvesting.org, Yahoo Finance.

Diversification benefits are real
Of course, it's easy to look backwards and find great companies to have invested in. But what you didn't know 20 years ago was that the banking industry would collapse and take many former giants along with it. So, what if instead of $1,000 in each of those nine stocks, you instead invested your $9,000 by buying $900 in each of them, along with another $900 in one ultimately failing bank stock?

Yes, you would have wound up with a bit less than had you never invested in that failure. But as the table below shows, even a complete loss from that one stock would have only knocked your annualized return down a mere 0.6%:

Company

Industry

Consecutive Years of Dividend Increases

$900 Invested 20 Years Ago Became

Annualized Return

Diebold Business Equipment

58

$6,403.51

10.31%

3M Conglomerate

53

$6,751.44

10.60%

Coca-Cola Beverages-Non-alcoholic

49

$6,547.91

10.43%

Stanley Black & Decker Tools/Security Products

44

$9,057.80

12.24%

Target Retail-Discount

43

$9,336.80

12.41%

Universal Corp Tobacco

40

$7,882.89

11.46%

Abbott Laboratories Drug Manufacturers

39

$6,183.02

10.12%

Nucor Steel & Iron

38

$11,410.71

13.54%

WGL Holdings Utility-Gas

35

$6,127.42

10.07%

Complete Failure Bank Losing money

N/A

$0.00

(100.00%)

Totals    

$69,701.50

10.78%

That's not bad for a portfolio where 10% of your invested capital got sent to a company that turned out to be worthless. Yet imagine what would have happened if you had put all your cash in the stock of that failed bank.

Ultimately, your money is at risk whenever and however you invest it. But by diversifying across industries while still investing in companies that look like they've got the strength to survive for the long run, you can protect yourself from a complete failure. It may not be a completely free lunch, but it sure is cheap for the value you get from it.

Coca-Cola and 3M are Motley Fool Inside Value selections. Nucor is a Motley Fool Stock Advisor selection. Coca-Cola is a Motley Fool Income Investor selection. The Fool owns shares of Abbott Laboratories, Coca-Cola, and Nucor. Alpha Newsletter Account, LLC owns shares of Abbott Laboratories. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Chuck Saletta holds no financial position in any company mentioned above. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 25, 2011, at 2:40 PM, jasenj1 wrote:

    401(k) matching is the better free lunch.

  • Report this Comment On April 26, 2011, at 1:11 PM, MrBawn wrote:

    @jasenj1: I disagree. Your employer could give you a raise in lieu of a 401k match. If your 401k match has a vesting schedule, your "free" lunch has a price of staying with your employer for however long it takes. If you had the choice between a raise and a 401k match, you should only take the match if the vesting schedule is reasonable and you already intend to contribute the maximum $16500 to your plan.

  • Report this Comment On April 27, 2011, at 9:10 PM, stevec5792 wrote:

    MrBawn:

    401(k) matches rarely match 100% of all your contributions up to the annual limit. More common is 50% of first 6% you contribute. 401(k) match is (almost) always better than an initial salary increase instead of foregoing 401(k) match forever.

    By law, company 401(k) matches must be vested by the end of the 5th year of employment. May be the end of the 5th year of 401(k) eligibility, but still this is a reasonable vesting schedule.

    Incidentally, the annual limit combining your contributions with your employer's, so if you would EXCEED the annual limit, better to get the match in your pay instead.

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Chuck Saletta
TMFBigFrog

Chuck Saletta has been a regular Fool contributor since 2004. His investing style has been inspired by Benjamin Graham's Value Investing strategy. Chuck also can be found on the "Inside Value" discussion boards as a Home Fool.

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