Where do you stand?
Let’s walk, step-by-step, through the different aspects of constructing your optimal portfolio. To begin, you must first know where you currently stand. You would start with an in-depth evaluation of your income, liquid net worth, living expenses, debt obligations, and your liquidity needs.
Evaluating where you stand may take some time, but it will allow to see the strong points and gaps in your financial plan. This information will allow you to clearly define your investment objectives.
Know Your Risk Tolerance
Keep in mind, all investments carry some degree of risk. Assessing your personal risk tolerance is a key component of construction your portfolio. There is no question that there is a correlation between risk and reward. Investors seeking a bigger payoff must take bigger risks.
In finance, risk is defined as the level of uncertainty that your investments can negatively affect your financial situation. To achieve an appropriate reward in your portfolio, you must be willing to take some level of risk. So, you must ask yourself, “How comfortable are you with uncertainty?” How will you tolerate dramatic swings in the prices of your securities, income, or return?
Once you have determined where you stand, and defined your objectives, timelines, and risk tolerance, you can begin to build the pieces of your portfolio.
Once you have determined where you stand, and defined your objectives, timelines, and risk tolerance, you can begin to build the pieces of your portfolio. You will begin with asset allocation. You can think of asset allocation as the foundation of how you manage your portfolio’s risk.
Asset allocation is how an investment portfolio is divided among different asset categories, such as stocks, bonds, and cash. Let’s discuss the risks of different asset classes.
We’ll start with cash. The biggest detriment to cash is that it doesn’t grow. Because of this, it does not allow you to keep pace with inflation and will decimate your purchasing power over time.
Bonds are often viewed as an important holding, particularly in a traditional portfolio. Like cash, bonds do not generate enough to keep up with inflation. Furthermore, there is an inverse relationship between bond prices and interest rates. As interest rates rise, bond prices fall. Conversely, when interest rates fall, bond prices tend to rise.
Bonds also introduce credit risk. When you buy a bond, you are buying a certificate of debt. And the company must repay this debt to you, with interest, over time. Your payment depends on the issuing entity’s ability to repay that debt.
Most people hold stocks, or stock-backed securities in their portfolios. The quality, performance, and therefore risk of stocks varies significantly from company to company. Moreover, all stocks are subject to price fluctuations. Sometimes these price fluctuations are related to company specific issues like earnings reports, and other times they are a result of an overall market shift.
Real estate is another common holding. Like bonds, interest rates play a pivotal role in real estate. When interest rates rise, the cost of mortgaging properties becomes more expensive and less appealing to many potential buyers. Interest also affects capital flows and excessively high rates can cause a shift in the supply and demand of cash flow as well as rates of return.
Additionally, real estate is a very illiquid holding. It will take days or even months to sell a piece of property where stocks can be bought and sold in a matter of seconds. Also, many brokers make it easy to borrow against your stock portfolio to access cash. You will have to fill out mounds of paperwork and go through an approval process to borrow funds on real estate.
Historically, the different asset classes have reacted differently to economic conditions. For example, stocks tend to go up as bonds go down. By holding a mix of asset classes, you can reduce your overall risk of loss and smooth out fluctuations in performance.
Many people conflate asset allocation with diversification. Diversification is how you spread risk out within a particular asset class. Simply owning multiple different stocks is not diversification. Especially when you own multiple dividend-paying stocks within the same or similar industry.
Keep in mind, the purpose is not to achieve higher returns, but to mitigate the risk of downturns. Diversification allows you to limit your exposure to downturns and potential losses, but it can also so limit your potential gains. However, sacrificing yield may lead to greater safety through better diversification.
We like to start with three categories of stocks, Cyclical, Sensitive, and Defensive. Cyclical stocks will generally move in the same direction as the overall economy. A defensive stock tends to be more stable with goods that remain constant throughout all business cycles. Finally, sensitive stocks will have a connection to business cycles but may react to more specific factors related to their business.
Sector and Industry Diversification
Next, diversification can be viewed by sectors. Most investment data firms break out companies into 10 different sectors. They include Basic Materials, Consumer Cyclical, Financial Services, Real Estate, Consumer Defensive, Healthcare, Utilities, Communication Services, Energy, Industrials, and Technology.
The finest measure of diversification can be looked at by industry. With over 100 different industries, it would be difficult for a portfolio to have holdings in each. However, it can allow you to compare two companies within a sector to see exactly how similar they may be.
Each stock you own should represent a set percentage of your portfolio. An ideal number of stocks is between 15 and 25. Fewer than that can result in a lack of diversification and more does not add much value.
Remember, the purpose of diversification is to minimize risk for a given rate of return. Multiple studies have shown that adding more companies beyond 30 stocks has a minimal impact on reducing risk without adding to portfolio returns.
You should also consider the complexity of managing so many positions. Each can include commissions, fees, and bid-ask spreads when buying and selling shares. All those costs eat into your returns.
Dividend Paying Stocks
Next let’s dig into selecting dividend paying stocks. When you are evaluating companies to buy, it is important to look at whether their stock is considered a value or growth opportunity. A value stock indicates a mature company that has a lower expected long-term growth rate. A growth stock is an indication of a new company with high expectation of future growth.
Value stocks generally have a lower price-to-earnings ratio (P/E). Although there is no magic number, typically a P/E below 15 is considered a good buy.
Growth stock will have a higher P/E – usually 18 or above. You can also use the P/E of a common index to see if the market views a company as value or growth. For example, if the S&P 500 has an average P/E of 17, stocks with lower P/E could be considered undervalued and those trading at larger multiples have a higher long-term growth rate factored into their price.
When it comes to dividends, a value stock will likely pay a regular dividend, while growth stocks either do not offer a dividend or offer one at a lower yield. Keep in mind that dividends start with strong fundamentals.
Before you choose a stock, you should always analyze its earnings. You can start with Earnings Per Share (EPS). EPS is a measure of a company’s profitability. It will help you to determine whether the stock is over or undervalued.
P/E is a measure of valuation and tells you if a stock’s price is high or low relative to company’s earnings. By evaluating a company’s earnings trend, you will be able to see if they company is heading in the right direction as well as get an indication of whether a consistent dividend payment is likely to continue in the future.
The payout ratio is also critical to evaluate. Yield is the reason investors choose dividends. But there should be a balance. A stock with the highest yield should not automatically be considered the best holding. In fact, an excessively high yield can be warning sign of future dividend cuts because the yield may be impossible for the company to sustain.
Make sure you also check the company’s dividend growth rate, as well as whether they have maintained consecutive payment growth. You may benefit more in the long run from choosing a stock that with a history of dividend increases rather than one that pays a higher yield at the time.
TrackYourDividends is a great place to review, search, and select the companies you would like to invest in. Our Diversification tab allows you to see your existing portfolio and identify missing sectors and overweight categories and stocks.
Our individual stock research page includes all the critical fundamental data necessary to analyze a stock. With a focus on dividends, you also have easy access to payment history, yield measures, and growth rates.
Once you’ve identified what is missing from your portfolio, our Dividend Screener allows you to filter all stocks by a ton of different factors. Yield and sector are common screens, but we include payout frequency, as well as P/E.
We also allow Premium members to set minimum levels for our Proprietary Scoring Systems. Our Premium members find the most value in our Dividend Safety Score, which combines many of the most common data points for dividend investors into one number from 1 to 100 to evaluate the safety and potential for future dividend growth.
The Dividend Safety Score puts the greatest weight on dividend growth and consecutive payment increases. Nothing demonstrates the safety of future payments like a recent increase or a strong history of growing dividends. We view stocks with consistent growth and payments as better long-term investments than those the simply have a higher yield today. TrackYourDividends gives you the big picture of your portfolio, as well as the ability to drill down on the important ratios and details that matter to you as an investor.
One thing to note, investors solely focused on dividend stocks tend to include a larger percentage of value stocks than the market and often lack growth companies. This could cause you to underperform or miss out on returns when the growth sector performs particularly well. Buying lower-yielding stocks with more growth potential can create a more well-rounded, diversified portfolio.
Fees and Taxes
You should also carefully consider potential fees and taxes when selecting your investments, as they can be a drag on your portfolio performance. For each investment you have, make sure you are aware of any fees involved with acquiring, holding, or liquidating it.
When it comes to dividend-paying stocks, qualified dividends are more tax-efficient than ordinary dividends. Because qualified dividends are taxed at the lower capital gains rate, they allow you to keep significantly more of your income than a similar ordinary dividend. Many investors also assume all “dividend” payments are the same. Make sure you understand non-dividend payments.
Reassess and Rebalance
After you have selected your investments, you must regularly reassess and rebalance your portfolio. Overtime, you may experience diversification drift and become too heavily invested in a particular company or sector. This drift is more likely to happen in a DRIP where you are automatically reinvesting your dividends.
Rebalancing is the process of shifting the weightings of the assets in a portfolio back to your optimal allocation. You will find it beneficial to set and follow a regular schedule to evaluate your holdings.