Many factors contribute to a portfolio’s growth, one of the most important is having a diversified portfolio. Diversification is mainly about protection against unforeseen events, but dividends and compounding are designed to offset the cost of over-diversification.
There is no better example to illustrate the success of portfolio management in the long run than Berkshire Hathaway. Warren Buffett’s investment vehicle, it trades at $378k/share, a staggering level by all metrics.
Buffett manages a portfolio of forty-nine companies worth close to $300 currently. Over thirty of these companies pay a dividend, and more than two-thirds have a dividend growth strategy for at least five years in a row.
Offsetting Diversification Opportunity Costs Via Compounding Dividends
When building a portfolio, an investor must consider two types of risks – systematic and non-systematic. The first one, also called market risk, cannot be diversified no matter what. However, the second one can be diversified away by adding to a portfolio uncorrelated assets.
Diversification comes in many shapes and forms. One of them is to diversify within an asset class, another is to diversify within the industry, and goes to such lengths as to not own your employer’s shares – yes, that is a form of diversification too, not to put all your eggs (investment and salary) in the same basket.
Finance 101 tells us that a portfolio of over thirty securities should be well-diversified to avoid non-systematic risk. That is if the portfolio manager respects the correlation principle when adding new assets (i.e., +1 positive correlation, -1 negative correlation, as maximum, respectively minimum levels).
Berkshire Hathaway’s portfolio generates over $4 billion in annual dividend income, although not all holdings pay a dividend. Investors should keep in mind that every time a company announces a dividend, the share price adjusts with the size of the dividend. As a matter of fact, Berkshire is a curious case because it is a dividend “lover”, but yet it does not pay a dividend to its shareholders.
Diversification is a costly process. By pursuing it, an opportunity cost arises by not adding more to the company in your portfolio. However, as Buffet proved over the years, the cost is easily covered by the power of compounding dividends – a lesson to all investors, no matter the size of the portfolio they manage or want to build.