Last Updated on 21 November, 2023 by Samuelsson
A sign of a strong portfolio is to construct one that grows with you. What percent of my portfolio should be dividend-paying? Investors tend to incline heavily toward dividends-paying stocks, attracted by the compelling numbers. But it is not wise to think of dividends as a risk-free income. Indeed there are investors who claim that they can build dividend growth but the whole point of building a robust portfolio is to minimize risks especially those factors that investors have no control over. The importance of margin of safety cannot be underestimated.
Thus, your portfolio should not only have dividend stocks. You should also include compounders and perhaps other asset classes outside stocks. However, a specific percentage can only be determined by knowing your investment goals and risk tolerance. Thus it’s impossible to determine what percent of your portfolio should be dividend-paying stocks and how many of those you should have in your portfolio. We recommend looking for quality companies, not specifically dividend stocks.
It is also important to diversify your portfolio in more than just investing in one stock. You must diversify by in different sectors as well. Investing in stocks that are influenced by the same factors can be prone to unnecessary risks. Moreover, a dividend isn’t exactly income because it is simply a company’s shareholder equity distribution.
Nevertheless, this isn’t about demeaning dividends, it’s about creating the right set of asset allocation before realizing the off traits that come with dividends. Again it’s all part of diversifying the risks away when you plan on constructing a portfolio.
Correct asset allocation
Asset allocation is known to be a form of investment strategy aiming to allocate assets in a portfolio with an aim to balance risk and manage the assets with respect to an individual’s goals, investment horizon, and risk tolerance.
There are typically three main asset classes- fixed income, equities, real estate, cash, and its equivalents (these being the most relevant asset classes for most people). Each behaves differently with time and has their own levels of returns as well as risks.
Asset allocation simply means spreading your investments in a mix of bonds, stocks, real estate, and cash or money market securities.
Within these classes, there are subclasses – large, medium, small-cap stocks, international securities, emerging markets, fixed income securities, money market investments like Treasury bills, Real Estate Investment Trusts (REITs), etc.
While reducing risk, an investor aims to meet his desired level of return. To achieve that, an investor needs to understand the risk factors affecting the returns.
For instance, treasury bills are known to have the lowest risks as they are backed by the U.S. government but on the downside, they offer the lowest return. As of writing, they offer a paltry 0.8% return.
That’s why asset allocation is respective to an individual investor’s risk tolerance, aim, and time horizon. Every asset has its ups and downs, or what we call market fluctuations.
Thus, diversification based on different assets makes sure that if your more volatile assets are suffering, then the stable ones can balance out the total returns.
While a certain percent of your portfolio should be dedicated to dividend-paying stocks, the remaining should be allocated to other assets, which are more flexible and efficient than dividends.
Why investors are mistaken to call dividends an income is because a dividend is just a distribution of an investor’s equity in the company. Equity is the assets that the shareholders receive when the company is liquidated. Since dividends are paid from the shareholder’s equity, it decreases the business’s assets. You can just as well sell shares to get income.
Capital is transferred from the company right back to the shareholder’s account. Stocks are found to drop the same amount as the dividend as it goes ex. dividend because of this very reason. Thus, experts say that a dividend is a partial liquidation of the company because it is technically a transfer of capital.
Moreover, many investors take on the misconception of confusing dividends with coupons. Considering dividends as an income is not exactly smart and there are further disadvantages to them than what first meets the eye –
- Dividends are not guaranteed
- Investors have no control over dividends
- Dividends come with tax disadvantages
- Not enough risk diversification
- Distract from total returns
While receiving a dividend, it is not compulsory that your net worth will be higher than before, in fact, it could be lower if you are in a tax position. So instead of focusing too much on what you can transfer from your investment account to your cash account, try to compound effectively.
Compounding takes you towards investing further into a company’s growth and increasing your return.
Dividend payments, for many, tend to take the focus off the more important things like growth, maturity, and earnings. Moreover, a company that is capable of redeploying earnings is much a better alternative and beneficial than a dividend payer.
- DRIP/dividend investing is inferior to internal compounding
- Debunking dividend investing (arguments against dividend investing)
An optimal portfolio is personalized to each investor’s goals and risk tolerance.
Thus, while considering every asset class with its own level of return and associated risks (like mentioned before), an investor needs to speculate their own risk tolerance, objectives of investment, time horizon, money availability to invest as the grounds on which they allocate their assets. The aim shouldn’t be to have a specific target of dividend-paying stocks.
Investors with a longer time horizon and a good amount of money to invest tend to feel comfortable with high-risk options with high return potential. On the other hand, investors with a shorter span of time might incline towards less risky with low return assets.
Based on risk tolerance and to make the risk allocation process easier, many investment companies are known to develop a series of model portfolios. These model portfolios comprise different proportions of different asset classes satisfying a focused level of investor risk tolerance. These model portfolios go from conservative, moderately conservative, moderately aggressive, aggressive to very aggressive.
Following these model portfolios can help inventors set priorities based on their personalized goals and requirements.
What percent of my portfolio should be dividend-paying? Conclusion
A smart investor should analyze and allocate the significance of the percentage of an asset in their portfolio strongly based on estimating total earnings and opportunity costs instead of picking just dividends with attractive yields.
Moreover, the best thing to do is to keep an open mind and be flexible while allocating assets in your portfolio for improved investment results.
Apart from the technical aspects of diversifying based on different markets and sectors, it is important to ponder on your own comfort zone of knowledge and tolerance for risk to meet your goals for investing in the first place. It isn’t easy to ascertain what percent of your portfolio should be dividend-paying.
– How much of my portfolio should be allocated to dividend-paying stocks?
There isn’t a one-size-fits-all answer. The percentage of your portfolio dedicated to dividend-paying stocks should depend on your individual goals, risk tolerance, and investment horizon.
– Why is diversification important in building a portfolio?
Diversification, both in terms of stocks and sectors, is crucial to mitigate unnecessary risks. Investing in stocks influenced by different factors helps spread risks and balance total returns.
– What is the misconception about calling dividends risk-free income?
Dividends are not risk-free income; they are a distribution of shareholder equity. It’s essential to understand that dividends are not guaranteed, and they come with disadvantages such as tax implications.