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Building
a Stock Portfolio By Jodye Deal Article published in The Network Journal magazine
The first step in building a portfolio is to assess your
financial picture by determining your investment objectives, as well as establishing an
acceptable risk tolerance level. Next, look
at the constraints that may be involved when building your portfolio. Constraints to consider are your time horizon and
liquidity needs. Your time horizon is perhaps
the most important constraint. Time can be an
investor’s best friend or worst enemy. The
longer the time horizon, the more risk the portfolio can tolerate. Liquidity is the ability to readily convert an
asset into cash. Your portfolio should fit your investment goal. Maybe you’re investing for retirement, your
child’s education, or a new home. Whatever
your goal, it gives you vital information. It
tells you how long you’ll be investing (your time horizon), and how much of your
investment you can put at risk. The closer
your goal, or the less you can afford to lose, the more you should focus on preserving
your capital. Create an Investment Policy Statement to force yourself to put your investment
strategy in writing and commit to a disciplined investment plan. Provide an overview of your current situation and
what you expect from your portfolio. How many
years will I be investing? How much do I
expect to earn each year over inflation? How
much of a loss can I accept over a three-month period, a one-year period, and a five-year
period? The Investment Objectives portion of your policy statement details what
you’re trying to achieve with this particular portfolio and in what time frame. What is my financial goal? How much will this goal cost annually? In the Investment Philosophy section, you’ll articulate what is
important to you as an investor. What’s
my philosophy on: risk, core versus non-core
investments, diversification, trading, costs, and taxes?
Before you buy or sell any security, make sure that your actions reflect your
philosophy. If they don’t, ask why. Maybe you shouldn’t be buying or selling that
stock. Perhaps your action is based on
short-term performance, or a hunch about what the market is going to do. Your actions should be based only on your
investment philosophy. Your core investments should be made up of stable, blue-chip
companies. Big and boring is the key to a
core investment. Great core stocks share a
handful of qualities. For starters,
they’re profitable, consistently earning great returns on the money shareholders have
invested. We measure return on capital for
companies by the return on equity (ROE). It’s
easy for a company to generate a large ROE in one year.
However, core holdings offer impressive ROEs year in and year out. Core stocks are reliable growers. They may not be growing at the same pace of a new
company, but their earnings are predictable yearly and they may pay out dividends to their
shareholders. Core companies are also
financially healthy. In other words, they
don’t take on a lot of debt. They
generate loads of free cash flow, or cash flow after spending. Classic-growth stocks, examples of core
investments, have mature and solid profitable businesses. Core holdings can take up 100% of some portfolios. In others, these investments account for 70% to
80% of assets. There’s no rule for how
large your core ought to be. However, I
suggest that core holdings take up a minimum of 50% of your portfolio. After all, these are solid, long-term investments
you are relying on to help you reach your goals. So where do the rest of your assets go? Into non-core investments, or the supporting
players in your portfolio. Non-core holdings are the stop-and-go investments that may
juice up your returns. Small-cap stocks could
also fall into this category for some investors, simply because they tend to be more
volatile than large-cap investments. Use non-core investments for diversification and growth
potential. For instance, if your core will be
exclusively large-cap stocks, you may want to add small-cap or international stocks to the
non-core portion of your portfolio. While you
probably wouldn’t want to put a significant portion of your portfolio in any one of
these types of investments, they do allow for the possibility of extraordinary returns. Of course, they also generally carry a higher
level of risk. But as long as you limit the
more-risky portion of your portfolio, you are not likely to threaten the bulk of your nest
egg. How many investments should you have? The problem with owning too many stocks is that
you can easily lose sight of the forest for the trees.
You start out as an investor with an investment goal and a portfolio tailored to
you, and turn into a collector who has forgotten what your goals are. Recent studies show that the volatility of stocks has risen
over the past few decades. Additionally,
individual stocks are behaving less like other individual stocks. As a result the number of stocks you need to mute
volatility likely is no less than 15 stocks. After building your portfolio, it requires regular reviews. You need to supervise it to make sure it stays on
track. Look for unexpected changes in your
portfolio. If you find some, you need to
determine how significant these changes are, and if they in any way threaten your
long-term investment plan or your portfolio’s short-term volatility characteristics.
This article was published in The Network Journal. Jodye Deal, contributed this article for the New York-based magazine. If you have questions on investing, please send them to Investing@GazelleAssociates.com. |
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In previous articles we covered topics such as, ideas for the
small investor; diversification and risk; investing rules; and surviving a volatile stock
market.