The Straight Dope On Diversification

I recently received this comment and question from reader “DB”, and once I saw that my response had crossed the 1,000 word threshold, I decided it was worthy of its own post. The question is about why it can be inadvisable to jump into the market all at once upon receiving some kind of windfall. Specifically, here is what DB had to say:

“Hello Tim – Thanks for this article! I like your writing style. I am just now constructing a dividend portfolio and it has been quite the learning process. I am wondering if you can address a question I have on building the portfolio regarding actually making purchases. I have seen a few authors caution the new dividend investor to not buy all your stock picks at once but to make the transition over time. Why is this? I assume the authors are telling us to identify the stocks we want to purchase and then wait for the appropriate entry price? Although I understand the share price is important and I do try to find value, If I am buying a quality company for a long-term position how important is share price?

Theoretically, if I found 20 DGI stocks I wanted to buy tomorrow and I believe they are fairly priced, what is the risk in  buying them all in one day?

I hope my question is clear. Thanks for your insight.

DB”

The answer to that question largely depends on how long you plan to invest, and what are the amounts in question. If you are just starting out with $10,000-$25,000 in seed money and you have decades of investing ahead of you while you anticipate simultaneously earning money from your labor, then it probably makes sense to go ahead and invest it all at once.

But if, say, you are guy in your 50s with a wife and kids that just sold his business for $1.5 million (after tax), then it makes sense to take a hard look at time diversification by gradually deploying the money over a 3-5 year time period.

Look, when we invest, there are three kinds of diversification that we practice.

The first kind is among the asset classes—some financial authors write that you should own not only stocks, but bonds as well, and maybe real estate, precious metals, and other asset classes across the board. Bond rates are a joke right now—you could find more interest income going through your couch cushions than you could get investing $10,000 into a relatively short-term US bond fund—and the problem with gold and silver is that they do not do anything.

The type of asset diversification that I would find most appealing would be mixing real estate with stock ownership. Ideally, I’d want to use a real estate position as an engine to permanently fund new stock purchases over the course of my life. Let’s say you own a $200,000 rental home in the clear with no debt on it and use that to supplement a stock investing program. Assuming it’s capitalized at 10%, you’d have $20,000 in annual rental income coming in each year. Of course, you have to deal with BS like taxes, maintenance, and other costs that will subtract from the amount that actually ends up in your pocket, so I would calibrate my expectations by assuming that $10,000 will actually end up in my checking account each year.

That gives you a little over $800 to invest each month. You could have $100 put into Exxon Mobil, Becton Dickinson, Nestle, Clorox, Procter & Gamble, Dr. Pepper, Lockheed Martin, and Johnson & Johnson each month for about a dollar in fees each month. You’d be using your real estate to automatically become an oil, household products, soft drink, military defense, and healthcare tycoon over the course of the decades, and the beauty of this strategy is that this build-up would be the result of past efforts, with little new labor on your part being necessary to keep your wealth-building machine chugging along nicely as you go through your life. In particular, that $800 coming in each month is going to be a great source of fresh cash so you can make new purchases when we see another sweeping stock market decline like 2008-2009 again.

The next type of diversification involves the removal of sector risk: in particular, you want to set up your life so that a few concentrated failures can’t wipe you out. For instance, right now, I’m probably too exposed to the oil sector. I can’t stop buying BP, Royal Dutch Shell, Conoco, and Exxon. Some people need their morning cup of coffee to come alive, well, I need a buy order for an oil supermajor to go through to get the juices flowing. I’m going to try to fix this by setting up a 1-2 year period of my life where I do nothing but buy Coca-Cola, Disney, and Colgate-Palmolive stock (those are the kind of companies that I could honestly say have a very good chance of still being profitable when it’s time to put dirt over my head and gift the household balance sheet over to charities, niche passion interests, kids, grandkids, and select friends). The point is that you should be aware of where you are the most exposed, and then draft a plan to decrease that exposure over time (some people make changes instantaneously once they identify a risk, and that strategy is cool, too. I just don’t like selling things, so I use a strategy that allows me to use new funds to balance things out, but the catch is that it takes a couple years).

In the example listed above, I used a $200,000 house for shorthand to make my point. But if you had no other assets to your name, I’d rather own two houses for $100,000 to hedge against the risk of vacancies and/or a tenant that has trouble paying, but more likely, I’d come up with a plan to get two or three $150,000 houses under my belt over a 10-15 year stretch of time (personally, I find life a lot more fun when I dedicate my energies to coming up with new ways to make money and buy new assets, rather than spending my time focusing on how to shuffle existing assets around out of a vague optimization desire).

Allright, with all that said, I can finally get to the crux of your question: the third kind of diversification, which involves easing into the stock market over 3-5 years because you received some kind of lump sum in your life. The point of time diversification is this: it is annoying as hell to make an all-in wager right before the stock market crashes. If you buy 1,000 shares of Coca-Cola at $40, and then see the price fall to $30, you have to deal with that obnoxious moment when you pull out the calculator and realize that you could have bought 1,333 shares and gotten $372 more in starting income if you had just waited a year.

Yeah, this is definitely a first-world problem, but still, you don’t want to be the guy that deployed all of his cash in 2007 and then got ticked off in 2008 and 2009 because he didn’t have fresh cash to deploy. But if you take that $1.5 million and put $300,000 to work every year for five years, you can reduce the odds of falling victim to the “buying high” experience.

Plus, when you deploy the money over time, you get two additional benefits: one practical, and one psychological. The practical benefit is that, if you screw up with the first $300,000, you still have 80% of the money left to invest to learn from your mistakes. Most people get better at a particular craft the more time they spend at it, and it’s reasonable to think that your “Year 5” investments will be more deliberate and intelligently conceived due to the four years of experience that you employed before it.

And secondly, it’s fun constantly deploying money into the market. You are always scoping out new opportunities and you can see the $300 in passive income that gets added to your balance sheet immediately upon each $10,000 you invest. That’s the kind of thing that can make it even more fun to wake up in the morning.

The only drawback of this approach is that while the money is not invested, it’s by definition not earning dividends, interest, rental income, and so on. It becomes a weighing act—in my case, I’d want to avoid “buying high” if I had a a whole lot of money to deploy all at once, and so I could deal with the income not yet received. Other people might say, “Hey, I need $50,000 in annual income to be satisfied, and I can get that much in passive income by deploying all the money now, so that’s what I’ll do.”

That’s my long way of answering: It depends. Hopefully some of that helps, DB.

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4 thoughts on “The Straight Dope On Diversification

  1. Scott says:

    Tim,

    Your plan sounds a lot like mine, but in reverse. I am building the stable income of the portfolio, and will be adding in the real estate portion over the next few years. One of the tricks of real estate is the leverage factor, which you've completely left out of this example. Instead of earning your mythical 800 a month, if you leveraged out 50% of that, earned 400 a month (50 dollars to each of your 8 companies as an add on) and used the 100K to buy 12,500 of each of those 8 companies to start with, its another completely different way to look at the same equation.

    In terms of the question at hand, I'm a huge fan of buying in smaller chunks over time. I've yet to find a situation where going all in on day one would have been my best scenario. I will say this, the last point, knowing your goal and being able to reach it, really does add to the equation. Meeting your goal should be the priority, not what everyone else tells you to do. Sometimes we get in the way of our own best interests.

    Scott

  2. I'm continuing to enjoy reading your work, here and on SA. I'm guessing the pattern of production has something to do with a study schedule…

    I have had this dilemma about cash burning a hole in my pocket. Partly, it's a lack of discipline on my part, but there's more to it than that. Legitimately, cash earns almost nothing at the rate banks or brokerages pay interest these days. That makes it hard to sit on cash.

    So, an interesting question is how to make the cash work, even while you invest incrementally over time.

    One thing I have been doing to beat the anxiety produced by 'cash on the sidelines' is to selectively use cash covered puts and covered calls to continue to keep cash in motion and produce new cash. I'm not as thrilled with covered calls, because I'm a buy-and-moniter investor and I don't like having to start a position over with a new cost-basis if the shares get called away. On the other hand, if I know a stock I'd like to own but the price is too high, a cash covered put is a decent way to earn somewhere between 5-12% annualized on the cash, while I'm waiting for a better entry point than what is offered by the market. If the stock dives and I get shares put at lower than my strike price, the put premium protects the purchase to a point below the strike price. There are other ways to protect the position using options, but the point is that using options selectively allows you to hold some cash for incremental investment without the anxiety of cash earning no income. It can be complementary to the buy and hold bias of the dividend growth investor.

    Nathan

  3. Josh says:

    "Although I understand the share price is important and I do try to find value, If I am buying a quality company for a long-term position how important is share price?-DB"

    while reading through Warren Buffett letters to shareholders, this is what he had to say about purchasing excellent companies at a high price.

    For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments"- Warren Buffett 1982 letter to shareholders

  4. says:

    Tim, this is a great write up. Even if I only had 10 – 25k lump sum, I still would split that amount into probably three purchases. The reason could be that the price of those stocks would fluctuate and I like waiting for a lower price to buy more shares cheaper. I quite take it as a game. When I initiate a trade, I tend to take that trade as a benchmark for my next trades and try to wait for the price to get below it to purchase cheaper. In volatile market this works perfectly, in a downtrend market this also works very well. In a strong uptrend, this method may be questionable, but over my investing career it never happened to me that the stock left me horribly behind. For example AT&T, when I was purchasing it at some point the stock sprinted up and I thought it was without me, but today, the price dropped below my average purchase price so I will be adding more shares. Being 100% invested would leave me without cash and I like to keep some for unexpected once life time opportunity which may occur in the market. So I tend not to use all cash at once.

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