One of the keys to profitable investing is stock selection. It does not matter how intricate the strategy is to buy and sell, if the stocks themselves are duds you will lose money. But what is the basis for stock pick selection? Which shares should you buy?
Why Have a Portfolio?
Before we build a portfolio we need to ask the question as to what a portfolio is and why we should have it at all. An investment portfolio is simply a group of stocks that you hold. A minimum portfolio size would be two stocks. But why not invest solely with one good stock?
The stock market is very diverse with many unknown factors. One could compare it to a garden full of vegetables. If you wanted to be sure to have food to harvest in the fall despite differing bugs and insects that attacked different crops, what would you do? If you planted only one crop, perhaps corn, the possibility lies that a corn eating pest could wipe out your entire crop. Only by diversifying can you protect the goal of having food to harvest.
The stock market is no different. For unforeseeable reasons the market may go up or down and this will have varying effects on different stocks. Some growth stocks may plummet in a bear cycle while other stocks such as ones based on gold may actually go up. To protect your portfolio with the goal of financial security, you need to have a variety of investment products.
Must Follow Portfolio Rules
Before we even begin to think about which stocks would make suitable candidates based on our trading psychology, we need to cover some basic trading principles that need to govern our portfolio creation. In no particular order here are the rules:
- Quality stocks with strong fundamentals
We are in this for the long haul. Picking penny stock might be great for some sideline speculation but for our portfolio to achieve financial security we want sound stocks that can weather hurricanes.
- Diversification
We are talking about stocks in different sectors, but also diverse in the amount of stocks. Many experts say that 10 to 12 stocks is the base for a good portfolio. Our goal is to have a substantial toehold in a few different types of markets so we can prosper from the varying cycles. Of course, we do not want to spread ourselves too thin. We will diversify as much as our capital will allows us to have a meaningful position in each stock.
- Entry and Exit Strategy
The point of this article is not to give technical analysis. But we should definitely have a plan of when to take profits, when to sell even if at a loss, when to invest in new stocks, and when to go to cash. A simple system is to trade with the overall market trend. Complex systems might use numerous technical analysis tools in tandem. Our portfolio should have some stability and not be a day trading account, but still have flexibility to maneuver with the changing markets.
- Portfolio Expectations
Building a portfolio should be made with a long term goal. While it might be a fanciful idea to double your investment every year with some very high risk methodology, this should not be the basis for our expected portfolio return. We need to pick realistic targets. If our returns fight inflation and beat other investment products we should be content. We are building a portfolio for tomorrow not today.
Building a Customized Portfolio
Portfolios do not come with a cookie cutter to make a prefabricated basket of stocks suitable for every investor. First we need to analyze the investor and then select stocks that match the profile. To do so we need to consider three main areas: time, risk, reward.
Time: how long do you plan to hold this portfolio? Do you plan to convert it to cash when your kids enter college? Is it a retirement portfolio? Are you planning to hold for five years or 35 years? This will greatly influence the type of stocks you select. As well, the age that you are also is a factor. If you are younger you might pick a different set of stocks than if you are retired and want your portfolio to remain stable.
The length of time and your age are major factors in stock selection. In general, the younger you are the higher risk you can assume. The longer you have to pick stocks the more fundamental factors will come into play.
Risk: how much risk are you willing to assume? All three factors of time, risk, and reward are closely related. If you are younger you can assume more risk. But that doesn’t mean you should. A careful analysis of your psychological profile will reveal if you have the stomach for high risk. Before you run out to see a psychiatrist, ask your spouse how you perform under stress. Or how do you feel when your home value falls in half? Do you take it in stride confident that it will soar in the future or do you lose sleep and incessantly worry? This may be a clue as to whether your portfolio should have high risk stocks and to what degree.
Return: what sort of return do I want and need? Most will want fantastic gains. But let us be realistic… the ASX as tracked by the ASX 200 index had an average annual return rate of 3.5% from 2002 until the beginning of 2010. Granted we also experienced a horrific drop in 2008, but this is how investing works.
A return should at least beat inflation by a few percent per year or we should simply give our money to the banks for long term deposits. A long term investment of 10 to 15 percent per year is a good target to shoot for However, lower risk might mean lower rewards of 5 to 6 percent after inflation. Of course, the return target needs to be adjusted based on our age and penchant for risk.
Adding Stocks to the Portfolio
Now that we have some idea of the time frame to hold, risk we are willing to take, and realistic returns we want, we can now pick stocks to match these criteria. There are two major types of stocks that we will be looking at: growth and income.
Growth implies primary appreciation of the share price while income stocks rely more heavily on dividends to create a cash flow. Our expectation for overall profitability with growth stocks might be around 7 - 10 percent per year, and closer to 5 or 6 percent when discussing income stocks. Of course this is after inflation. How do we use these different stock categories to create different portfolios customized to our needs? That answer will be highlighted in the next two accompanying articles.