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Diversifying your high yield portfolio: HYP Part 3

Don’t put all your eggs in one basket

We’ve already considered the attractions of dividends and what makes a good individual high yield share. Part 3 now looks at how many different shares you need to get a squad of high yield shares fit for the long-term.

(For those who like spoilers: Part 4 will offer an illustrative portfolio assembled using real share data, Part 5 will look at buying your HYP with a lump sum versus regular savings, Part 6 at managing your HYP over the long-term, and finally (if all goes to plan!) Part 7 will touch on high yield investing in the US and other non-UK markets, and also look at some potential pitfalls to the high yield approach. Don’t miss out: subscribe for free via RSS).

So, how many and what kind of shares do you need to buy to graduate from making a few ‘punts on the market’ into owning a well-diversified portfolio of high yield shares?

Unit trust managers, private investors and pension funds alike have been constructing high yield portfolios for decades, but despite this (as regular readers will expect) there aren’t any watertight rules. Every investor’s circumstances and portfolio will be different, and so it’s vital you’re happy with your own selections.

That said, I’d urge three guiding principles among all others when picking your team of high yield shares:

  1. Diversify
  2. Diversify
  3. Diversify

Or in the spirit of diversification, how about: ‘Diversify, Differentiate and Don’t Duplicate’.

Diversification in investing terms is a long word for a simple principle: Just the same as your old dad said when you were deciding which girl to call back, don’ t put all your eggs in one basket.

In HYP investing, that means you ideally want each member of your share portfolio to come from a different area (or ‘sector’) of the economy – banking, telecoms, food and drink, mining, and so on.

Like this, if one sector is down in the dumps to the extent that dividend payments are threatened – for instance, a crash in the price of commodities that threatens mining profits – it’s unlikely that all the others sectors will be at the same time too.

A side benefit is that if you diversify – resisting siren calls to go ‘all in’ and only buying the current sexiest sector – you’re unlikely to get caught up in a stock market bubble, such as dotcoms at the end of the late ’90s or railroads in the 1930s.

More likely when buying high yield shares is being tempted to overly favour one sector in order to get a higher yield.

As I write for example, bank shares are being hammered by fears of a credit crunch. Their low price means high yields for investors.

If you put half your money into several of these high yielding banks rather than only having one or two banks in your portfolio, you have indeed reduced the fallout from any one bank running out of cash or ‘doing a Leeson‘. But you still leave yourself at the mercy of unfolding economic events seeing all your bank shares cutting their dividends at once, with drastic consequences for your overall income level and, most likely, the value of your portfolio.

This is perfectly possible with every sector – utilities could be hammered by a tougher government, retailers could suffer in a recession, oil and gas shares could be hit by a collapse in the demand for fuel, and so on.

Don’t risk it. Diversify!

Diversification has been well championed by one of the clearest online exponents of the high yield approach, The Motley Fool‘s writer Stephen Bland. Under his pen name of ‘TMFPyad’, Bland initially proposed the high yield approach to retirees seeking a better-value alternative to annuities.

As a strategy for retirement, security of income is doubly-important. You don’t want grannies forced to busk in the streets to make up for a shortfall in their dividend income!

But younger investors aiming to grow their capital pot as well as their dividend income (by reinvesting dividends) would also do best to follow the diversification route in my opinion. After all, the key aim of following the HYP strategy is to secure a growing dividend stream while reducing the risks of stock market investing as much as is possible. There’s no need for recklessness here.

How many shares do you need for diversification?

Personally, I’d look for around 15-20 shares, from as many different sectors as possible. More than that and your overall yield will start to fall too much if you’re buying them all at once (but see Part 5). Fewer, and you’re increasingly exposed to the risk of a particular company doing very badly or even going bust, and so taking out a heftier chunk of your portfolio.

Some investors (such as the aforementioned Stephen Bland) are happier with fewer shares (10-15, say), and it’s true that mathematically the risk reduction benefits from adding more shares do fall off after 10-12, becoming rather negligible by the time you add a twentieth share.

But what’s the harm of adding a few more companies, provided you’re not compromising your selection criteria?

With today’s low-cost online brokers, the cost of buying shares in an extra five companies is a small price to pay for the extra security.

Unfortunately, in our less than ideal world you’re likely to have to buy shares in two or more companies from the same sector to complete even a 15 share portfolio if you want to keep the yield up (because high yielders tend to come from the same sectors at any particular time, due to those sectors being out of fashion). With 20 shares you get a better chance to spread this duplication risk over several sectors, and thus keep up the diversification.

At the other extreme, if you look at the holdings of Equity Income funds (unit and investment trusts that pursue a high yield strategy) they tend to hold shares in far more than 20 companies. There are rules barring them from holding only a handful of companies, but I’m not sure why they go so much further; presumably they see risks in a FTSE 100-dominated portfolio that they seek to diversify away from, at least over the shorter time periods they tend to be judged on. (We’re buying for the long term, so we will try to ignore the wobbles of our portfolio from month to month).

Less generously, the high yield strategy is an easy one to implement, so perhaps fund managers feel overpaid if they’re not buying more companies and constantly tweaking their portfolios – all the time running up more charges for investors, of course!

What about a very small portfolio of five to ten shares? The main benefit of going for a concentrated portfolio is that you can pick the very highest decent-looking yielders, whereas if you’re assembling a 20 share line-up you’re likely to be pulling down the portfolio’s overall income with your later selections.

If you’re young (or already rich) and you’re sure you can sleep easily if a company in your portfolio hits the skids, then you might chance a smaller portfolio (though I’d still strongly suggest no fewer than 10 shares). You may well outperform over the long-term, as compensation for those sweaty nights and extra risk… or you might not. That’s investing for you.

To summarize, you want a portfolio with:

  • At least 10 different high yielding shares but I’d go for more like 20.
  • Shares covering a wide range of companies, which ideally all operate in different sectors of the economy.
  • Each share selected according to the safety criteria discussed in Part 2.

Next time we’ll look at how this works out in practice with an example portfolio.

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