One of the tenets of financial independence is the recommendation to acquire multiple streams of income. So do stock do this? Well, the answer is both: yes and no. Let’s look at both sides of the issue.
The case For
We can say that dividend stocks are a set of multiple streams of income if you own stock in more than a few companies, and these companies are in multiple industries. By owning stock in companies that operate in multiple industries, you are covered by virtue of being in different segments of the economy. If one industry segment declines, you still have income coming from companies from other segments.
The case Against
We can say that dividend stocks are not a set of multiple streams of income, because stocks are just one asset class. There are others, like real estate, private businesses, art, and (gasp!) crypto-currencies, for examples. Sometimes markets decline. And stock can generally be more volatile than some other asset classes.
The case
For me, I invest mostly in stocks. I contend that stocks are much simpler to invest in, and are generally more liquid. This is not to say that stocks are foolproof of course. From time to time stocks can and do decline. But so can all other asset classes listed above. Absolute safety is not a function of risk assets.
I focus on dividend-paying stocks: simple, much less volatility than stock prices, and my ownership of shares increases over time because I generally reinvest dividends, and so on.
By making the effort to be diversified in companies in different business segments, I can avoid the “all my eggs in one basket” danger.
The Quesion
So, if I would like to understand how diversified I am, or aren’t, how would I do that? The question is: how can I determine the market sector a company is in? And what about the industries in each sector?
The Answer
The specific information for each public company is listed in numerous places in the financial press. One simple example is at Yahoo.com’s finance section. Look up a company’s data, click the Profile link, and adjacent to the corporate information is the Sector, and below it is the Industry.
There are currently eleven market sectors that serve as indicators what the main area of business for all companies. These sectors, and the number of industries in each are as a follows:
Communication services – 5 industries
Consumer discretionary – 11 industries
Consumer staples – 6 industries
Energy – 2 industries
Financials – 7 industries
Healthcare – 6 industries
Industrials – 14 industries
Information technology – 6 industries
Materials – 5 industries
Real estate – 2 industries
Utilities – 5 industries
By making a list of all stock one owns, or might own, it is simple to determine if one is overweighted or underweighted in each segment or industry. The sector and industry list is of course subject to change over time.
This is not a recommendation to be equally invested in each segment and/or industry. As previously mentioned, many investors have opinions about avoiding some segments and/or industries and/specific companies. Perhaps investing in some industries is not in keeping with one’s values. Or one feels that some industries are low growth, or subject to obsolesence. These are decisions that each investor makes.
Another Path
One way towards diversification is to use index mutual funds. The kinds of mutual funds do provide some diversification as they follow a specific index. But it is important to understand the index that the mutual fund is following. While indexes can provide broader coverage compared to one or a few specific stocks, indexes can be lopsided in their own way.
The Dow Jones Industrial average contains stocks from only 30 companies. The index is a price-weighted index, which means the higher the price of an individual member stock, the more it is represented in the index. So each company represented in the index is different percentage in the index.
The Standard & Poors 500 index is also a market-weighted index, based on the capitalization of the company. This also means that as a stock price increases, its percentage in the index increases.
There are indexes which are not market-capitalization based, but these are not as common.
Not Really A Conclusion
While diversification is important, there is no one perfect way to diversify. Every investor should keep in mind that diversification is a personal decision.
How do you implement diversification? Do you diversify at all? Let me know here.
The illustration of the jellyfish Discomedusae was by German biologist Ernst Haeckel (1834-1919). He produced illustrations of many jellyfish. He became associate professor of zoology at the University of Jena, Germany in 1862. Courtesy Library of Congress.
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