Investors are captivated by the thrill of stock selection, yet the often-overlooked strategy of portfolio diversification holds equal, if not more, importance.
Embarking on a simplified diversification approach, I invite you to explore seven essential rules for strategic diversification in defensive dividend portfolios.
The Three Risks of Diversification
Diversifying to Reduce Company Risk
The most straightforward form of diversification involves allocating investments across various avenues.
Assessing Company-Specific Risk Tolerance
There’s a tradeoff between risk tolerance and investment allocation, reflected in the number of stocks held.
Most investors tend to overestimate their risk tolerance, leading to emotional decision-making when a significant investment underperforms.
Setting a position limit, like the 6% target size rule, can curb overexposure and ensure emotional detachment from investments.
Diversifying to Reduce Industry Risk
Diversifying across companies becomes ineffective if they operate in the same industry. Implementing a limit on holdings within a sector is crucial to diversifying industry risk.
Diversifying to Reduce Country Risk
Focusing purely on company and industry diversification overlooks the impact of country risk. Applying a cap on the portfolio’s exposure to a single country mitigates the effects of localized economic downturns or geopolitical turmoil.
Geographical diversification can be achieved by considering internationally-focused stocks or funds.
Integrating Defensive Stocks
Further fortifying a portfolio involves the strategic inclusion of defensive stocks, amplifying resilience in economic downturns.
Tilting the Portfolio Towards Defensive Stocks
Including a proportion of holdings from defensive sectors, with steadier dividends, infuses stability into the portfolio.
Setting a lower limit on the proportion of defensive stocks held ensures a balance between stability and potential returns.
Tilting the Portfolio Away from Highly Cyclical Stocks
Restricting exposure to highly cyclical sectors safeguards the portfolio from economic fluctuations. However, some resilient companies within these sectors can still be considered for inclusion.
Tilting the Portfolio Towards Large Companies
Favoring large-cap companies bolsters the portfolio against market volatility, leveraging their robustness and resilience to adversity.
By implementing these rules, investors can diminish exposure to individual company, industry, and country risks while emphasizing a lean towards more resilient and larger companies. Diversification indeed presents itself as a valuable stratagem in the investor’s arsenal.
Disclosure: The author holds shares in Legal & General, Chesnara, MoneySuperMarket, Next, Direct Line, Unilever, and British American Tobacco