Portfolio Diversification

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When it comes to portfolio diversification, there are many ways to determine the most suitable type of diversification for your portfolio. Portfolio size, age and risk appetite are useful and simple ways you can use to allocate the cash, bonds, growth stocks and dividend stocks in your portfolio.

This article will focus on the portfolio allocation between dividend and growth stocks.

1. Portfolio Size

The simplest and most straightforward way to decide how much to allocate between dividend and growth stocks is by portfolio size. In general, the larger your portfolio, the larger proportion you could allocate to dividend stocks. The following illustration will explain the rationale for this:

Assuming individual A has $100k, while individual B has $800k. We assume they invest in 5% yield dividend stocks—individual A will receive $5k in annual dividends, while individual B will receive $40k.

It makes more sense to allocate a larger proportion of your portfolio to dividend stocks if you have a larger capital to begin with, as the passive income generated is reasonably large enough.

Conversely, if you have a smaller portfolio, it may not be ideal to allocate a larger proportion of your portfolio to dividend stocks for income, as it will not be as lucrative as it is for those with a larger portfolio. To reap higher returns even with a relatively small capital, allocating a larger portion of one's portfolio to growth stocks will be more meaningful in meeting your target returns.

For example, investing in a growth stock with 12% annual returns will allow an individual with $100k to reap $12k a year, compared to just $5k from 5% yield dividend stocks. Once your portfolio grows bigger over time, you could gradually start to allocate a larger proportion to dividend stocks.

Target Portfolio 

Whether a portfolio is large or small varies significantly from person to person, as the definition of what constitutes a "large" or "small" portfolio size is relative rather than absolute. Therefore, as a guideline, you could first set a personal target portfolio size (e.g., $1m portfolio by retirement at 65 years old).

A reasonable target portfolio size should be able to generate sufficient passive income to cover your monthly household expenditure in retirement. If you are able to generate 5% yield on a $1m portfolio ($50k per annum), and if you spend around $4k a month in retirement, then a $1m is a reasonable target portfolio size. However, if you spend $8k a month in retirement, then you might need to aim for a $2m portfolio size to generate sufficient passive income to cover your monthly expenditure. 

Once you set a target portfolio size to achieve, then you could target to allocate most of your portfolio to dividend stocks by the time you reach retirement. For instance, if you are 30 years old now with 70% in growth stocks and 30% in dividend stocks, and you plan to retire at 65 years old, then you could plan to gradually allocate more of your portfolio to dividend stocks as you age. 

Some guidelines when setting your target portfolio 

1) Set the estimated dividend yield from your dividend stocks.

2) Calculate your estimated annual expenditure at retirement.

3) Set your target portfolio to generate sufficient passive income for retirement.

4) If you exceed your target portfolio, the surplus can be allocated to growth stocks. 

For example, if you estimate you can earn 4% from dividend stocks, and you require $60k annually for retirement. Your target portfolio should be $1.5m by retirement. In the event you achieved $1.8m by retirement, you could allocate the $300k surplus to growth stocks, or otherwise you could leave it in dividend stocks to earn 4% yield.

In summary,

For smaller portfolios, you could allocate a larger proportion to growth stocks to grow your portfolio at a faster rate to achieve your target portfolio, which will generate a higher level of future passive income (for retirement).

For larger portfolios, you could allocate a larger proportion to dividend stocks to grow your portfolio by generating passive income which can be reinvested to generate even more passive income to achieve your target portfolio.

2. Age

Age can also influence your portfolio allocation because your age determines your investment horizon, which will influence how much you are able to earn from compounded returns over time.

Assuming two persons live till 80 years old; a 30 year old will have a 50 year investment horizon, while a 60 year old will have a 20 year investment horizon. 

The difference between a 20 year and 50 year investment horizon is HUGE.

For example, if both individuals invest $100k in growth stocks yielding 12% per annum and compounded, the 30 year old will have $28,900,218.98 when he is 80 years old, while the 60 year old will only have $964,629.30 when he is 80 years old.

This shows that your investment horizon has a huge impact on your compounded returns. A 30 year difference in investment horizon can produce an almost x30 times larger portfolio at a 12% compounded annual return.

In general, younger people have a longer investment horizon. As such, they can afford to allocate a larger proportion of their portfolio to growth stocks, which are usually more volatile in the short term but provide much higher compounded returns in the long term. As most younger people have limited capital, investing in dividend stocks for income may not be as lucrative for them as it is for older people with a larger capital.

Example

Let us assume a 12% per annum return on growth stocks and a 5% yield on dividend stocks, and two individuals—a 30 year old with $100k to invest, and a 60 year old with $500k to invest. Assuming the 30 year old invests his $100k in 5% yield dividend stocks and reinvests all dividends, he will have $1,146,739.97 in 50 years.

In contrast, if he invests in growth stocks with a 12% per annum return, after compounded gains, he will have $28,900,218.98 in 50 years. Although there is only a 7% difference in the return per annum, over 50 years, investing in growth stocks compounded over time will give the individual a whopping x25.2 times larger return than dividend stocks. 

This is unlike the 60 year old whose $500k will become $1,326,648.85 in 20 years when invested in 5% yield dividend stocks, while becoming $4,823,146.54 if invested in growth stocks with a 12% per annum return, which is only a x3.63 times higher return. Due to a shorter investment horizon, the difference in investing in growth and dividend stock for the 60 year old individual is not as drastic as it is for the 30 year old individual.

Power of Compounding 

The power of compounding will allow you to grow your portfolio exponentially even with limited capital. The Rule of 72 is a useful tool to calculate how many years it will take for you to double your portfolio, assuming you reinvest all dividends and gains earned.

For example, if your portfolio grows at an average of 12% per annum, your portfolio will double in approximately every 6 years (72 ÷ 12 = 6).

My view

Personally, I believe most of the top growth stocks are found in the US—companies such as Microsoft, Alphabet, Amazon, Adobe, Meta, etc. The HK market also provides some excellent growth stocks, albeit at a higher risk. Unlike the US or SG market, the HK market is more volatile and is strongly influenced by China's political situation.

In contrast, the SG market has many high quality dividend stocks, such as the three banks, some blue-chip stocks, and REITs. With a strong currency and most dividends being tax-exempt, having SG stocks in your portfolio is a good way to build a reliable flow of passive income.

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Rule of X

As a guideline, to diversify between growth and dividend stocks, you can allocate X% of your stock portfolio to dividend stocks where X is your age, with the remaining allocated to growth stocks. For instance, if you are 35 years old, you could allocate 35% of your stock portfolio to dividend stocks and the remaining 65% to growth stocks.

Similarly, if you want to decide how much to allocate to cash/bonds and stocks respectively, the Rule of X is applicable as well. For example, if you are 35 years old, you could allocate 35% to cash/bonds, and the remaining 65% to stocks.

You can then further allocate the initial 65% allocation to stocks between dividend and growth stocks by using the Rule of X outlined above, e.g. 35% of the 65% allocation to dividend stocks and 65% of the 65% allocation to growth stocks. 

i.e. As a whole, you first allocate 35% to cash/bonds, then allocate the remaining 65% as such: 22.75% to dividend stocks (35% x 65% = 22.75%), and 42.25% to growth stocks (65% x 65% = 42.25%).

There is no hard and fast rule to portfolio diversification and allocation, but as a rule of thumb, the older you are or the larger your portfolio, allocating a larger proportion of your portfolio to dividend stocks instead of growth stocks may be better.

Conversely, if you are younger or have a smaller capital, allocating a larger proportion of your portfolio to growth stocks will enable you to reap large long-term compounded gains.

3. Risk Appetite

Ultimately, apart from your portfolio size and age, your portfolio diversification depends largely on your risk appetite. If you are willing to stomach the short-term risk and share price volatility of growth stocks (e.g., dropping 60% in a year) in return for the larger long-term gains, then it may be good for you to allocate more to growth stocks. 

Most importantly, invest only with money you can afford to lose. Investing with borrowed money or being highly leveraged might pay off in the short-term, but is highly unlikely to pay off in the longer-term.

When it comes to investing, erring on the side of caution will always pay off. Forgoing some potential returns for greater peace of mind is wiser than reaping high returns at the expense of having sleepless nights. Ensuring you invest only with money you can afford to lose will allow you to remain in the market to tide through the ups and downs, without having to cash-out at the wrong time because you are forced to do so.

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What if I need to cash out urgently?

If you happen to need to sell your stocks for urgent cash (although this should rarely be the case, as you should invest only with money you can afford to lose, and money which you do not need for your immediate needs), the better option is to sell your dividend stocks first, because unlike growth stocks, dividend stocks usually do not fluctuate as much. Therefore, buying in and out of dividend stocks is easier and less risky than buying in and out of growth stocks, because there is a chance that you may never get to buy the growth stocks at a lower or the same price you sold them at.

For example, if you need $10k of cash urgently, then selling your dividend stock yielding 5% a year is better than selling your growth stock yielding 20% a year. The opportunity cost of selling the dividend stock for urgent cash is much lower than selling the growth stock as the returns are lower.

If the growth stock is currently overvalued, then selling it if you need the cash urgently may not be a bad idea. However, it is important to ensure that you are able to buy back the growth stock at around the same price or lower, because oftentimes, it is easy to sell growth stocks at a good price, but it is difficult to buy it back at a good price, as growth stocks are usually on a long-term upward trend.

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Conclusion 

By exercising prudence in your portfolio diversification, you will be able to diversify your portfolio such that it meets your current needs and risk appetite. Remember that having a strong portfolio diversification does not happen overnight, but takes consistent hard work and discipline. As your portfolio evolves and changes over time, it is important to regularly revise your portfolio plans and targets.

Reassessing your portfolio's allocation on a regular basis and making the necessary changes in response to market changes will allow your portfolio to remain nimble and adaptive to changes amidst the volatility of the market and economy.

"Time in the market beats timing the market — almost always."

— Kenneth Fisher

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Disclaimer:

The content and information provided on this blog is solely for educational and informational purposes, and should not be construed as financial advice. The accuracy or completeness of the content and information provided in the blog cannot be guaranteed. Before making any investment decisions, it is important for readers to research and carry out independent verification of the information provided, or consult with a qualified financial professional. No warranty and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of actions taken based on the ideas or information found in this blog.

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