Successful investing is all about managing trade-offs. Your money faces a series of different risks that include things like:
- Investment failure
- Regulatory shifts
Any one of those risks (or others) can derail your best-laid investing plans. Unfortunately, there's no way to completely avoid financial risk -- even hiding your money in your mattress exposes it to inflation and the potential of loss due to theft or fire.
Your key weapon against risk -- and its own downside
One of the strongest weapons you have against risk is diversification. You can diversify where your money is invested (401(k), IRA, traditional brokerage accounts). You can diversify how your money is invested (stocks, bonds, real estate, cash). If you're like most of us, you even diversify when your money is invested -- through things like your paycheck cycle or when your existing investments pay their dividends or interest.
Diversification is a great protector against risk, but it comes with its own cost. That cost is that the further you diversify, the more you're forced to buy assets that don't have a legitimate shot of reaching your return targets. Legendary Peter Lynch called that problem "diworsification". In essence, too much of that good thing can cause problems.
According to a study reported in Investment Analysis & Portfolio Management, "the major benefits of diversification were achieved rather quickly. Specifically, about 90% of the maximum benefit of diversification was derived from portfolios of 12 to 18 stocks." That provides an excellent range for an investor looking to build a portfolio that benefits from the power of diversification without reaching too far into the realm of diworsification.
What that means to real-money investors
In the real-money Inflation-Protected Income Growth Portfolio, diversification is a key principle that protects the invested principal. Still, the portfolio's other key principles involve buying at decent valuations and owning stocks with track records of paying and raising their dividends and with the potential to continue doing so. That combination already limits the available universe of companies to invest in.
As a result, the diversification has to be handled in a way that it adds legitimate protection without hampering the portfolio's overall ability to deliver the income growth over time that's expected of it. The first 10 selections in the portfolio, covering half the initial investable cash, include:
- An industrial conglomerate
- A generic-pharmaceutical powerhouse
- A provider of staple foods
- An auto parts distributor
- A safety equipment provider
- A high-tech titan
- A toy maker
- An electric utility
- A shipping company
- A pipeline giant
That provides a reasonable base, especially combined with the above-quoted study that suggests 90% of the total benefits from diversification comes from the first 12 to 18 stocks. As a result, I'm now willing to somewhat loosen the portfolio's strict diversification criteria. I'm still looking to hold around 20 positions in varied industries, but I'm now willing to double up in an industry if there's a second company with both a compelling valuation and dividend growth potential.
For instance, one of the earliest picks for the portfolio was staple-foods maker J.M. Smucker (NYSE:SJM). Yet fellow foodie General Mills (NYSE:GIS) has a 113-year history of steady or rising dividends, a decent valuation, and gives reason to believe the trend will continue. There's no real reason to avoid owning the company making your Cheerios just because you also own the company making the Folgers coffee you're drinking with it. Diversification does ask, though, that you not go hog wild on food companies.
Similarly, prior to the financial meltdown, General Electric (NYSE:GE) had a better than 30-year history of increasing its dividend annually. Now that its base business seems to have stabilized and its dividend has resumed increasing, it may be worth considering. The big problem? Fellow industrial conglomerate and aircraft-engine maker United Technologies (NYSE:UTX) is already in the portfolio. Ultimately, there may be room for both in the portfolio, but only if they don't chew up too much of the available capital.
After all, entire industries can be taken down when there are fundamental shifts in the way the economy operates. The same financial meltdown that damaged GE completely took out Washington Mutual, which was once the nation's largest S&L. Even the surviving banking titans, like Citigroup (NYSE:C) are mere shells of their former selves. Citigroup's dividend, for instance, still sits at the $0.01 per quarter it fell to as part of the bailout that kept many major banks solvent.
The ultimate balancing act
When all is said and done, diversification can protect your overall portfolio from being taken completely under by either individual company collapses or by complete industry meltdowns. Still, too much diversification means you could be leaving your best ideas on the table simply because they're too close to other picks you've already made.
As with so much else in investing, it comes down to finding the right balance between the risks you're facing to be able to manage across them well. As for the Inflation-Protected Income Growth Portfolio? Diversification still matters and will still play a part in investment selection, but it won't prohibit me from picking a second company within an industry, so long as it looks like the best overall pick. With 10 pretty well diversified picks in the mix already, it's all about finding the right overall balance.