It might sound very obvious, but being a successful investor involves more than just finding good companies to invest in. You need to think about your investments from an overall perspective too! How do your various investments look when they sit side by side with each other? Do they work harmoniously together and compliment each other? Or are there some clashes and contradictions that could prevent your portfolio from performing as you want it to? Here we take you through some of the fundamentals of portfolio construction.
One Size Fits All? No!
To start with, there is no "one size fits all" approach to this problem. Many different investment philosophies exist, and each have their own set of strengths and weaknesses. The key thing is to think about your specific needs and wants, and then set-up your portfolio accordingly. It’s also true that an element of trial and error is natural here. New investors when starting out may like to try different approaches and just see what works best for them.
Diversity Is Key!
It’s an old idea, but that doesn’t stop it from being a good idea, in fact a great idea! One of the most important concepts to bear in mind when building a stock portfolio is that you should never put all your eggs in one basket. This means that you shouldn’t ‘bet’ too heavily on one stock, or even one sector, or one economy.
Success in the investment game often comes from many different and unpredictable directions, and so you need to make sure some part of your portfolio can be exposed to growth wherever this growth is coming from. For example, it would be foolish to gamble on a single biotech stock that may or may not soar in value over the next 5 years.
However, there is obviously a lot of great companies in this industry, some of whom will be very successful. Maybe a better approach would be to buy a fund or other investment vehicle that follows this sector and therefore will gain you some exposure to success stories in this field.
Simultaneously, it is also possible that the whole sector may fail to live up to expectations, and in this situation, it would be very useful for an investor to have some other stocks from other unrelated sectors of the economy in their portfolio. We will explore this core idea more below, but this should serve as an opening illustration of why diversifying your portfolio is so important.
Check Out: Strategies For Diversifying Your Portfolio
The business cycle will never end…
The next key point is that the cycles of boom and bust every economy goes through are here to stay. They never will end, and in fact, it would be bad if they did, as this dynamism is part of what powers the long-term growth of economies.
As such, investors need to ensure that their portfolio is ready for the inevitable downturns that markets and economies take. You need a good mix of aggressive growth stocks, more defensive value stocks, as well as including different sectors and different markets from around the world.
If you do this, the ups and downs of the business cycle will have a less extreme impact on your investments. This is because you will always have something that is performing ok, so your overall portfolio value won’t be too volatile.
Short Term vs Long Term
I guess by now you’ve accepted the main premise that it’s good to be diverse. It follows from this that you also need to think about what you are going to buy and hold for the long term, and what stocks you might buy and sell on a more regular basis.
Some companies will look like solid bets over the next decade, and some will be coming in and out of fashion in response to news and trends. Both types of stock can be great to include in your portfolio. You just need to be clear at the outset how much money you’re willing to put into each type and bear in mind that each time you buy or sell, some fees will usually be involved.
Read Also: Key Benefits of Investing In Stocks
How Many Stocks?
This is a huge question, and something I’m not even going to pretend has a right answer. Obviously, the more stocks you have in your portfolio, the more diversified it is.
This means it is less risky, as they will almost always be something in your portfolio that is going up. However, it also means that you have fairly limited exposure to each stock precisely because there are so many in your portfolio! It is, therefore, true that more stocks means more diversification, and this means less risk.
But this also means less potential reward from one stock rising, as it will be weighed down by everything else that may not be rising at the same time. So, you want to find a happy middle point where one or a few stocks rising will have an impact on the overall value of your portfolio, but without being too exposed to them.
As a very general rule, most investors tend to hold between 10-30 stocks at any one time, but this is not a solid rule that cannot be broken.
Time Is Money!
Something to factor in when choosing the number of stocks to include in your portfolio is how much time you’re willing to spend monitoring your positions.
With fewer stocks, you’ll generally need to be a bit more active. You’ll have to check what is rising, what is falling and why, and have to be thinking strategically about when you might want to sell out of something or buy into something else. This is because with fewer stocks, you’re much more exposed to their performance.
This approach is sometimes termed "active management", and some investors simply chose to pay someone to do this for them. With a wider basket of stocks, you are less exposed to the market’s daily rises and dips, and so it’s more sensible to just sit back and watch your investments grow over time.
This is what is sometimes termed "passive management", and investors for favour this approach often like to use index funds.
Build Your House One Room At A Time
You don’t have to buy your complete portfolio one Day One. It’s sensible to go slowly, adding one stock at a time. This way you can be totally confident that you have had the time to research and get to know the company and be secure that it’s something you want to put your money into.
This slow approach will also enable you to think about which sectors or countries you want to include in your portfolio. You can also choose to put more money into stocks you already own.
By going slowly month by month, you might see a small company growing that you want to become a regular investor in. Essentially, we advise you to add maybe one or two positions a month to begin with, and see how it goes from there.
When To Sell Out Of A Losing Investment?
One of the hardest questions ever investor has to answer is when to cut their losses a sell. Inevitably, you will have some investments that will decline, and when this happens you’ll face this choice.
The key questions to ask yourself are: Is this a temporary dip, or more of a long-term decline? These questions can be answered through research, and some investors also rely on gut feelings to help them decide. However, nobody gets these calls right every time! If the decline is thought to be short term, then it might be worth considering buying more – if you liked the stock before, it is now cheaper, so why not buy more?
However, if you feel the decline is long-term and the future direction of travel is down, then it could be time to cut your losses and sell your full investment. Finally, there have been numerous companies in the past who have survived and pulled out of tail-spins to rise to victory once again. If you are happy to hold for the long-term, then sometimes you can tolerate a fairly large decline in stock price – you might be rewarded later!
Don't Miss: 7 Safe Stocks That Won’t Bleed Your Portfolio
Large or small?
It is well known that smaller firms offer better growth prospects, but also bring more risk. Meanwhile, large firms will tend to grow less but should pay good dividends and are unlikely to collapse in value.
As such, you should aim for a good blend of both in your portfolio. One thing to consider is how long you plan to keep your money invested for. If you are relatively young, then you can afford to take a chance on riskier, higher-growth smaller firms.
This is because you have longer to let your investments go up, and so you can put up with a bit more risk. However, if you were for example close to retirement, it would be safer to keep your money in large and stable companies.
You wouldn’t want to retire in a market dip and lose maybe 30% of your savings simply because the market was down at that point. A younger person could recover from this dip, as they are not going to withdraw their money for many years, and by this time the market will of course have recovered and risen above its previous level.
Local or global?
Diversification has already come up quite a few times, but here we are using it in the international sense. You should avoid relying too much on one stocks from one country, and as much as possible to try to gain exposure to markets around the world.
This is because a recession in one country will almost always cause its stock market to decline. But if you have different countries and regions represented within your portfolio, you should be insulated from this affecting your investments value too much.
The big developed markets of Europe, America, the UK, and Japan are obvious places to look for good quality shares. It is also worth thinking about including some stocks from emerging markets too, if you have some appetite for risk. Emerging markets often achieve higher growth rates than developed countries, but their companies may be more volatile and unpredictable.
eToro - Buy Top Stocks With No Commission
eToro have proven themselves trustworthy within the industry over many years – we recommend you try them out.
Your capital is at risk. Other fees may apply