This post is the fifth in a series exploring the myths and misunderstandings about dividend investing. The goal of the series is to argue that many investors following a dividend-focused strategy may be better off with broad-based index funds.

Dividend Myth #5: It’s easy to build a well diversified portfolio of Canadian dividend stocks.

One of the most appealing aspects of dividend investing is the tax advantage: dividends from Canadian companies are eligible for a significant tax credit. This credit does not apply to US or international stocks, however—indeed, foreign dividends are taxed as regular income and are subject to withholding taxes. That’s why many dividend-focused investors hold only Canadian stocks in their portfolios.

Income from Canadian dividends is an important part of most retirement plans. But if you’re staking your whole future on a small number of domestic stocks, you should be aware that your investment strategy may be a lot riskier than you think.

Understanding risk

First, a little financial theory. All equity investors face systematic risk, which is simply the risk associated with the market as a whole. Systematic risk cannot be diversified away: even people who own index funds with thousands of stocks are not immune to a market crash.

A second type of risk is called is unsystematic risk: it applies only to investors who hold individual stocks. For example, a company’s share price will fall if it declares lower-than-expected earnings, but such an announcement will have virtually no effect on the broad market.

The important point is that investors are rewarded for taking systematic risk: it is the reason stocks have the highest long-term returns of any asset class. However, investors are not compensated for taking unsystematic risk. Holding a small number of stocks in a portfolio offers the possibility of dramatically beating the market, but this potential is outweighed by the much higher downside risk.

That’s why investors should try to eliminate unsystematic risk altogether. They can do this by diversifying their holdings across many stocks, so that no single company can torpedo their portfolio.

How many stocks do you need?

So how many stocks do you need in your portfolio to eliminate single-company risk? A commonly held belief is that 15 to 30 stocks are enough, so long as they are spread across several sectors. However, recent research suggest that number should be much higher.

An analysis in The Journal of Investing in 2000 found that “even 60-stock portfolios achieve less than 90% of full diversification.” A 2008 paper from Dimensional Fund Advisors argued that a 50-stock portfolio would need to beat the market by 10 basis points per month to reward the investor for the additional risk.

In his review of the research on diversification,  William Bernstein puts it this way: “To be blunt, if you think that you can do an adequate job of minimizing portfolio risk with 15 or 30 stocks, then you are imperiling your financial future and the future of those who depend on you.”

A narrow slice of a narrow slice

Even if you could properly diversify a portfolio with 30 holdings, there’s still the matter of spreading these across all sectors of the economy. And if you’re picking only from a menu of Canadian dividend-paying stocks, that is virtually impossible.

The makeup of the Claymore and iShares dividend ETFs bear this out. Claymore’s CDZ includes companies that have raised their dividends for at least five years: there are fewer than 40 of these, and about 30% are in the energy sector. Its iShares competitor, XDV, includes the 30 highest yielding stocks in the country, and it’s 52% financial services companies. The broad Canadian market is already poorly diversified, and focusing on dividend stocks just compounds the problem.

Canadians who select individual stocks rather than using ETFs have more freedom, but they can’t avoid sector concentration altogether. They can pick a few telecoms, utilities, REITs, and a railroad or two. But the technology, health care and consumer retail sectors (which make up about 45% of the S&P 500) are all but absent from the mix.

No one cares about diversification when their concentrated bets are working well. But what happens if Canadian banks suffer a crisis like US banks did in 2008–09? We dodged that bullet, but do we really think our financial institutions are immune from something similar? What happens when oil prices fall, as they have many times in the past? Or if foreign competition changes the Canadian telecom space?

Why expose your whole portfolio to idiosyncratic risks like this, when you’re not likely to be rewarded for doing so?

Seeking diversification abroad

It’s not just dividend investors who face risks from Canada’s small, narrowly focused stock market. Even Couch Potatoes who hold the entire S&P/TSX Composite have 70% of their money in three sectors (financials, energy, and materials). That’s why all Canadian investors should give serious thought to addressing their home bias.

If you have a significant portion of your investments in Canadian dividend stocks in a taxable account, consider taking a broader view with your RRSP. A diversified mix of index funds or ETFs (bonds, US and international stocks, and other asset classes) can dramatically reduce the risk of your overall portfolio. Canada is a wonderful place to invest, but there’s a big world out there beyond banks and energy.

Other posts in this series:

Dividend Myth #1: Companies that pay dividends are inherently better investments than those that don’t.

Dividend Myth #2: Dividend investors are successful because they select excellent companies and buy them when they are attractively priced.

Dividend Myth #3: Dividend-paying stocks are a substitute for bonds in an income-oriented portfolio.

Dividend Myth #4: You can beat the market with common sense: just focus on blue-chip companies with a competitive advantage and a history of paying dividends.

Dividend Myth #6: Investors who follow a dividend growth strategy will eventually beat the market on yield alone.