Wednesday, July 10, 2024

The Importance of Diversification and Risk Management

With Dividend Growth Stocks, when I am wrong, the most I can lose is the amount I invested, minus any dividends I allocated elsewhere.

But when I am right, those winners can pay for several "losers".

Let me illustrate it with a few examples.

About 13 years ago, I initiated a position in Walgreen's (WBA)

It offered a good valuation at 14 times earnings and a dividend yield of 2.50%. It also had a high dividend growth of 17%/year over the preceding decade, as well as a 10% earnings growth. Ironically, many dividend investors at the time viewed it as a "growth stock". It was for the first time in a long time been available at a very good entry valuation too.

I held the stock for a long time.

However, I sold the stock after it cut dividends on January 4, 2024. If you look at the total returns, it basically lost money. While I probably did a little better because I put the dividends elsewhere, rather than DRIPped them, I also added to it as well.

About the same time in 2011 I also initiated a position in Lowe's (LOW).

It offered a good valuation at 16.60 times earnings and a 2.90% dividend yield. The company had high dividend growth of 31.50%/year over the preceding decade. However, earnings per share growth was 9%. I bought it as the valuation was pretty good, despite the fact that the housing crisis was somewhat of a headwind.

I still own the stock. It has paid for several Walgreen's. 

This is why it is important to allocate a certain amount to a security, and then give it as much opportunity to compound earnings, dividends and intrinsic value as possible.  While some companies would fail to live up to expectations, there would be a few that would wildly exceed them. It is hard to predict the specific winners in advance. The best on can do is stick to their process, and patiently sit on their stocks. There is a natural Pareto principle in investing too, where a small number of companies would likely be responsible for a large portion of returns.

Those lucky few would be the difference between a portfolio making a decent return and a portfolio barely even making a return. If someone had sold them early, they would have likely sabotaged their portfolio. Hence why it is important to water the flowers and pluck the weeds. 

In other words, keeps losses to the amount invested, so that limits losses when you are wrong. But keep invested in a position for as long as possible, which gives you maximum chances of reaping the maximum potential returns from an investment.

It is also very helpful to review past investments, in an effort to learn and hopefully improve. I have learned the importance of not selling, and staying invested as long as possible. 

I have also learned that it is important to strike when I see an opportunity, rather than sit and twiddle my thumbs. Those are what Buffett calls "mistakes of omission". This is where you find a good company, but you fail to invest due to "reasons". 

I personally missed investing in Eli Lilly (LLY) in 2009, which had done tremendously well. I also missed investing in Pfizer (PFE), which hadn't. However, a combined invested in Eli Lilly and Pfizer would have done very well in a diversified portfolio. 

What is the point of this article?

It is to share experience, and lessons I have learned along the way.

This post illustrates the importance of having a diversified portfolio and practice sound risk management. Diversification can definitely protect against risks, and I am a big fan of it.

It's also important to manage risk, and have a plan of how much to bet on a company, when to sell and how long to hold for.

In a diversified portfolio, your winners would do much better than the losers. Even if you have a few bad apples, the winners would likely more than pay for them, and still result in an overall good results. 

One definitely needs to let the winners win for as long as possible, in order to pay for the losers down the road. Selling too early could be the difference between making money and losing money overall.

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