By: Dividend Sensei
Harry Markowitz, a nobel prize winning economist and father of modern portfolio theory, once called diversification “the only free lunch in finance.” In part two of this series I’ll explain why there is actually another “free lunch” that can massively boost portfolio returns over time. But in regards to diversification Markowitz was talking about market studies showing that through diversification, you can both reduce your risks while actually boosting your returns over time. Note that in this article I’m talking about diversification in a stock portfolio, not necessarily by asset class. However the underlying principle is for a mixed asset portfolio as well. There are two reasons diversification is so powerful, one intuitive and one not so much.
The intuitive reason that diversification works is because any single stock has a lot of risk. According to Professor Richard Foster from Yale University the average time a company spends in the S&P 500 is 15 years, down from 67 in 1920. Now that can be for a number of reasons, such as being acquired by a rival. However acquisitions were not as prevalent in the 1920’s and yet companies still usually died after a little over half a century. That’s because capitalism by definition is a cut throat fight for market share. Companies are always having to find new and better ways to win customers’ money, by providing goods or services better than their rivals.
Even the best run blue chips, such as legendary dividend aristocrats, (companies that have grown their payouts for 25+ consecutive years), can fall on hard times. They can even spiral into the abyss. For example GE is a perfect example of a once beloved aristocrat that once seemed to be the master of its industry. Its CEO Jack Welch was even named Forbes “CEO of the Century”. But it turns out that GE’s impeccable growth was built on a financial house of cards and it nearly went bankrupt during the housing crash. This former dividend aristocrat has now cut its dividend twice within a nine year period and may have to do so in the future.