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Limiting Risk: A Little Exposure To High Yield Goes A Long Way
Posted by: Dividend Mantra (IP Logged)
Date: July 29, 2014 04:54PM

One thing I’ve definitely noticed when constructing my Freedom Fund is that a little exposure to stocks with high yield can have a major impact on my overall dividend income.

Now, it should be noted that I don’t consider current yield as the most important metric when deciding whether or not to buy a stock. Every investment I make in a business is done so because I truly believe in that business’s prospects, I understand how they make money, I think they’ll be more and more profitable over time, and I believe they’ll share those rising profits with me in the form of increasing dividends. But that being said, current income is something I do think about because every additional dollar I’m able to generate from my investments puts me one dollar closer to financial independence.

Comparing Positions

However, the great thing is that just a sprinkle of high yield on top of a high-quality cake with a great foundation can really improve one’s prospects for generating more additional current passive dividend income.

I’ll show you how that works with a couple of holdings in my personal portfolio.

I currently own 140 shares of The Coca-Cola Company (KO) worth a total of $5,682.60 based on today’s price of $40.59.

Coca-Cola, in my opinion, is one of the best companies one can possibly invest in. They are a global beverage powerhouse with more than 500 nonalcoholic brands, 17 of them being billion-dollar brands. As such, I have a good portion of capital invested in the company.

Each share of Coca-Cola pays a quarterly $0.305 dividend, for a total of $1.22 per year. That means my 140 shares pays $170.80 per year in dividends. That amounts to about $14.23 per month.

It’s taken me a number of years to amass a position of this size in Coca-Cola. I’ve never made a lot of money in my life, but I’ve leveraged as much of my spare capital as possible over the last few years to build up investments in fantastic companies that pay rising dividends, which has in turn increased my passive income from $0 to more than $5,500 per year.

But what’s amazing is that a much smaller investment for me elsewhere in my portfolio produces almost the same exact dividend income.

I currently own 170 shares of American Realty Capital Properties Inc. (ARCP) worth a total of $2,255.90 based on today’s price of $13.27.

ARCP is a REIT that acquires freestanding commerical real estate and leases these buildings out to credit worthy tenants. I like the business, but I’m not quite as big a fan of ARCP as I am KO. ARCP has only been around a few years, and has grown tremendously over this time frame. Their history isn’t quite as rich as a beverage company that’s been around for more than a century, and so I have less of my hard-earned capital committed to this company.

But what’s fantastic is that this hasn’t hurt my dividend income at all, since ARCP has a yield of 7.54% right now compared to KO’s 3.01%.

And this is how that plays out: Each share of American Realty Capital Properties pays a quarterly $0.8333 dividend, for a total of $1.00 per year. That means my 170 shares pays $170.00 per year in dividends. That amounts to about $14.17 per month.

So I have less than half of the capital committed to ARCP than I do to KO, yet the income is about the same due to the yield on ARCP being more than twice what an investor can get with shares on KO.

Spreading And Limiting Risk

So this allows me to spread my risk out appropriately in terms of how much capital I can have committed to a company while still keeping an overall attractive dividend income profile across the entire portfolio.

This can be thought of as weighting your positions in terms of the dividend income they produce rather than how much the investments are worth. I don’t weight my portfolio like this, but I can certainly see the merits of doing so because it allows you to see how your dividend income is spread out across the positions.

I plan to eventually own 50 or so positions across my entire portfolio because my Freedom Fund will eventually fund my entire lifestyle, paying for all of my expenses via the dividend income it generates. But owning 50 or so positions means that if one investment were to eliminate its dividend, I still have 49 or more other positions paying out dividends. Factor in even modest dividend raises from the other ~49 investments and my dividend income will likely not even miss a beat, or perhaps even increase.

Of course, how this works in reality compared to theory all really depends. It depends on which investment cut or eliminated its dividend, how much you had invested with that company, the yield on shares, how much you have invested with the other positions, what kind of raises you receive from your other investments, and how effective you’re able to reallocate the capital from the potential sale of an investment that cuts or eliminates it dividend.

But what this article is designed to show is that you don’t necessarily need as much invested in high-risk, high-yield investments to positively affect your overall dividend income to the same level as lower-risk, lower-yield investments that are deemed to be safe foundations of your portfolio.

As such, I construct my portfolio with this in mind. I purposely have more capital committed to companies likeJohnson & Johnson (JNJ), PepsiCo, Inc. (PEP), and Chevron Corporation (CVX) than I do to companies like Omega Healthcare Investors Inc. (OHI) and AT&T Inc. (T).

Conclusion

Your positions do not need to be equally weighted in terms of value across the entire portfolio because not every company presents the same risk/reward relationship or income potential. A very small investment in a rather risky investment with a substantial dividend can positively impact your overall dividend income to the same level as much more capital committed to a high-quality company with a much lower yield. The reason you see this relationship in the market is because there is typically more demand for investments that perceived to be safer and higher in quality. As such, the yield is lower due to investors driving up the price.

I believe my primary responsibility as an investor is to reduce risk wherever possible, and limit the chances of capital loss. Every investment decision I make is with the thought of limiting downside, rather than maximizing upside. With that in mind, I have purposely invested most of my wealth in companies that I view to have the least amount of long-term risk. Meanwhile, I can invest relatively small amounts of capital in companies that appear to have more risk, but due to that risk perception being widespread, shares typically have higher yields and as such I can generate similar levels of dividend income while investing much less capital, and, therefore, limit the risk of losing significant portions of my capital.

Full Disclosure: Long KO, ARCP, JNJ, PEP, CVX, OHI, and T.

How about you? Do you have your positions weighted equally, or do you invest according to perceived risk to reduce downside while factoring in income?

Thanks for reading.



Stocks Discussed: KO, ARCP, JNJ, PEP, CVX, OHI, T,
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