Wednesday, November 10, 2010

How to Get Rich Slowly DRIP by DRIP: Asset Allocation

Asset Allocation and rebalancing are disciplines that force you to “buy low and sell high” without trying to time the market. For them to work you must be invested in two or more uncorrelated products (investment vehicles) – preferably negatively correlated (meaning that when one goes up the other goes down).

The Limits of DRIP Asset Allocation
DRIP investments are essentially limited to large-cap dividend-paying stocks, with a few international ADR’s and a few mid-cap stocks thrown in for flavor. Because of this limitation, diversification of asset classes is a matter of selecting dividend-paying stocks from different industries and countries.

My Diversification Plan
Currently, my DRIP portfolio contains:
1. HAS (Hasbro) – an American toy company
2. SJM (J M Smucker) – an American food company
3. CTL (CenturyLink) – an American telephone company
4. JNJ (Johnson & Johnson) – an American pharmaceutical & medical equipment company

I’m also planning to add:
5. BHP (BHP Billiton) an Australian mining company.
6. A suitable non-US oil & gas company.

My portfolio is reasonably diversified across industry sectors. However, it could be improved by the addition of an industrial like Nucor (NUC), a defense company like General Dynamics (GD), a utility like NextEra Energy (NEE), and a financial like Cincinnati Financial (CINF).

The Main Weakness of My Portfolio
My portfolio’s main weakness is its concentration in American stocks. This is an historical accident. As I learned more, I added to the portfolio. Plus, my primary Transfer Agent, Computershare, sponsors few international choices. BHP Billiton is offered thru Wells Fargo Shareholder Services. It’ll be my 1st foray into alternative DRIP Transfer Agents.

If I eventually add more companies to the planned 6-stock portfolio, I’ll focus on international companies. However, there’re some US based companies, like Coke (KO) that receive more than 70% of their revenue from outside of North America. I’d count them as international even if they’re headquartered in the US.

Assign Asset Allocation Percentages
Once a DRIP portfolio has been acquired, or perhaps chosen in advance, it’s time to decide what portion of the portfolio will be targeted for each stock and ADR. A simple even distribution works just fine. For example, if you have a five-stock DRIP portfolio you might assign a target of 20% of the total market value to each of the five stocks.

There’re no rules for this percentage allocation. It depends entirely on how you feel about the relative risk and return of each investment. You may consider your utility stock to be the safest investment and chose to allocate a higher percentage of the portfolio value to it. And, you might decide that your integrated oil company stock is certain to appreciate as oil supplies become more expensive world-wide. If so, your asset allocations might be 35% in the utility, 35% in the integrated oil and 10% in each of the other three stocks.

Again, there’re no rules except the ones you make. However, once made, change the rules seldom or the benefit of rebalancing will be lost.

Portfolio Rebalancing
Selling DRIP stocks is much harder and more expensive than buying them. That’s good. It encourages you to choose carefully, buy consistently, and hold your stocks for a long time. However, it also limits your flexibility in rebalancing your DRIP portfolio.

Your primary method of rebalancing is to allocate new money to stocks that are below their target values leaving those above their targets alone. This makes rebalancing take longer – spreading it out over a number of months of continuous investment.

Most financial advisors recommend rebalancing a portfolio every year. Some recommend every other year. Others advise watching the portfolio every month but rebalancing only when it gets out of balance by more than 15% or 20%.

The differences in advice are largely due to different approaches to getting the most benefit from the “buy low & sell high” discipline. Letting a “hot” investment run far enough to capture a significant gain before taking the gain is always a tradeoff with the timing of when the “hot” investment will cool.

Market timing being something few people can pull off consistently, you must establish a rule for when you’ll rebalance. Once established, this rule must be adhered to and seldom changed. Or, once again, you’ll lose the benefit of the rebalancing discipline and be no more successful at timing the market than the rest of humanity.

To Sum Up
1. Select a diversified portfolio of DRIP stocks & ADR’s based on industry and country.

2. For each stock choose a target allocation (a percentage of the portfolio value) and change the targets reluctantly.

3. Decide when, or under what conditions, you’ll rebalance your DRIP portfolio back to the target allocation percentages.

4. Execute the rebalancing as planned by redirecting your new monthly investments until the target allocations are restored.

The next topic will be using DRIP’s as gifts to children – or grandchildren.

Link to Topics in the Special Report - How to Get Rich Slowly DRIP by DRIP

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