Is Your Stock Portfolio Sufficiently Diversified?

Diversification simply means spreading your risk. The idea is that different sectors and industries are exposed to different risks and therefore, they will take turns outperforming or underperforming in different economic or market environments.

For example, you wouldn’t want 50% of your dividend portfolio in bank stocks because they would get hit hard in a financial crisis or recession.

Although during a recession, likely all sectors and industries will be impacted, some will recover faster than others. That’s where it’s advantageous to hold a diversified portfolio versus one that’s concentrated.

Stock portfolio building is a journey that’s not necessarily a straight or rosy path

Today, I’ll introduce a few ways to think about stock portfolio diversification. Here’s a dividend stock portfolio building example.

Diversification by sector and industry

The Global Industry Classification Standard (“GICS”) categorizes stocks across 11 sectors, 24 industry groups, 69 industries, and 158 sub-industries.

The 11 sectors are Communication Services, Consumer Staples, Consumer Discretionary, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Real Estate, and Utilities.

The rule of thumb is to not own more than 25% of one’s stock portfolio in a sector. You don’t necessarily need to invest across all 11 sectors, though. For instance, many Energy, Materials, and Industrials stocks have more unpredictable earnings due to the ebbs and flows of the economic cycle. 

Therefore, it might serve investors (especially new investors) better to start investing in the other 8 sectors first. However, coming out of a recession — in an economic expansion, Industrials stocks would do very well.

Notably, Biotech stocks, in the Health Care sector, are highly unpredictable as well. Small-cap biotech stocks could be multi-baggers or make investors lose their shirts!

Some sectors have more industries to choose from. You don’t need to invest in all industries. Play with the interactive tool at the GICS website to see the various industries.

Stock diversification

Generally, you don’t want to be over-exposed to a stock. In the worst-case scenario, a company can go bankrupt, leading to its stock being worthless. The general rule of thumb is limit stocks no more than 5% of your stock portfolio. So, if you bought a stock to make up 2% of your stock portfolio, you would consider trimming it if it grows to more than 5%.

However, there’s an opposing view. Some investors would hold their winners, particularly those that are multi-bagger prospects. For example, it would be a pity if investors sold growth stocks like Amazon (NASDAQ:AMZN), Alphabet (NASDAQ:GOOGL)(NASDAQ:GOOG), and Netflix (NASDAQ:NFLX) along their investing journey because their stock allocations maxed out for their portfolios due to the price appreciation of the stocks. 

Here’s a graph that illustrates the growth of an initial $10,000 investment in the growth stocks versus the Canadian stock market and U.S. stock market proxies. 

AMZN Total Return Level Chart

Total Return Level data by YCharts

For diversification purposes, you want to invest in a group of stocks that don’t move in tandem. For instance, you don’t want to invest in similar companies like Enbridge (TSX:ENB)(NYSE:ENB) and TC Energy (TSX:TRP)(NYSE:TRP) that rise and fall together.

ENB Chart

Data by YCharts

Dividend income diversification

Some dividend stocks have a big yield. So, even if you have a reasonable allocation of the stock (say, 5% of your stock portfolio), it could contribute to, say, 10% of your dividend income. Depending on how safe that dividend is, you may or may not be comfortable with getting a large percentage of dividend income from a single stock.

Here’s a concrete example.

For example, Enbridge stock yields 6.6% at writing. If it makes up 5% of a $500,000 stock portfolio that yields 3%, ENB stock will contribute about 11% of the portfolio’s dividends this year.

  • Stock portfolio size: $500,000
  • Stock portfolio dividend income per year (assume 3% yield): $15,000
  • Enbridge dividend income/year: $1,650 (11% = 1,650/15,000)

In summary, when you hold high-yield stocks in your portfolio, check how much they contribute to your annual dividend income. If they contribute a lot (say more than 5%), your dividend income is exposed to greater risk when one or more of these high-yield stocks cut their dividends.

Think in Market Cap Size

Other than diversifying your stock portfolio by sectors, dividend contribution, and stocks, investors should also see their portfolio diversification in another perspective: market cap size.

How much is your stock portfolio allocated to small-, mid-, and large-cap stocks?

Small- and mid-cap stocks grow much faster than large-cap stocks. So, smaller-sized companies can deliver much greater long-term returns than large-cap stocks, because businesses grow the fastest when they’re small.

Understandably, as individuals, small- and mid-cap stocks are much riskier than large-cap stocks. So, always hold a group of small- or mid-cap stocks. Alternatively, you can gain exposure by investing in small- or mid-cap ETFs like Vanguard Small-Cap Growth ETF (NYSE:VBK) and iShares Russell Mid-Cap Growth ETF (NYSE:IWP).

Depending on your risk tolerance, investment horizon, and comfortability, you might have larger or smaller allocations to small- and mid-cap stocks.

For example, you might allocate 10% to small-cap stocks/ETFs, 15% to mid-cap stocks/ETFs, and 75% to large-cap stocks/ETFs in your stock portfolio. Remember that there’s no need to rush into buying any stocks immediately, as there will always be bargain buying opportunities during market corrections or bear markets.

Diversify by growth and yield

Typically, high-growth stocks have no to low yields, while slow-growth dividend stocks have high yields. Unless you need income now, it’s better to have a mix of growth rates and dividend yields in your stock portfolio. 

For investors with a long-term investment horizon (say +10 years), it’s most definitely better to own a larger percentage of higher-growth stocks. 

So, if you only invest in dividend stocks, don’t just focus on the current dividend income. Also, think about your portfolio dividend-growth rate, which would be the weighted average dividend growth rate of your dividend portfolio.

Here’s a simple dividend stock portfolio example, showing the calculation of the weighted average dividend growth rate.

Amount invested nowDividend Stock2021 dividend hike
$5,000Starbucks (NASDAQ:SBUX)9.8%
$10,000Enbridge3.1%
$5,000Comcast (NASDAQ:CMCSA)8.7%
$20,000WADGR:6.2%

Simple dividend portfolio with $20,000 invested now.

The average portfolio dividend growth rate for 2021 is 7.2%, while the 2021 weighted average dividend growth rate (“WADGR”) is ~6.2%.

Calculations: 

  • 7.2% = [(9.8% + 3.1% + 8.7%) / 3]
  • 6.175% = [5,000/20,000 * 9.8% + 10,000/20,000 * 3.1% + 5,000/20,000 * 8.7% ] = 2.45% + 1.55% + 2.175% 

What if you just started investing?

Let’s say you’re just starting out and investing $1,000 a month. Obviously, all the above rules go out the window (for now). Why? The first month, you’ll have $1,000 in a single stock, which makes up 100% of your stock portfolio. Your stock portfolio will simply diversify over time as you contribute regularly and expand your portfolio.

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Disclosure: As of writing, we own shares of AMZN and NFLX.

Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.

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