With the Australian sharemarket booming over the past few years, people are now more confident than ever about investing in shares but are they really constructing a winning portfolio?
The truth is that just about anyone can build their own share portfolio and achieve good returns without too much knowledge or risk. The key to being successful is to practise good portfolio management. So how do we do this?
What follows is a practical framework that will allow you to not only construct a profitable portfolio but ensure you only select stocks for your portfolio that have a higher chance of being consistently profitable. So let’s get started.
There are two critical areas you need to consider when constructing a portfolio:
- Managing risk, and
- Money management.
We have all heard that we need to diversify in order to reduce risk, but how many of you actually understand diversification in its true sense. According to the financial services industry you can achieve greater diversification by investing in managed funds than if you invested directly yourself. But in my experience, managed funds hold up to 100 different stocks in their portfolio, which not only increases transaction and other costs, but also the risk of the portfolio.
While it is true that diversification reduces risk, a portfolio of shares that is over-diversified is exposed almost exclusively to market risk, which cannot be eliminated by diversification. Let me explain.
An investor who chooses to invest in a particular market is exposed to the risks inherent in that market, such as economic influences of inflation and interest rates that affect the market as a whole. Therefore, the market risk remains regardless of the degree of diversification of the portfolio.
However, an investor must also contend with specific risk, which refers to the risks inherent in a company or particular events in a sector that influence specific securities. The total risk, therefore, is the sum of the market risk and the specific risk of the individual positions.
Obviously the specific risk is very high if you invest in only one stock, but the more a portfolio is diversified, the less the specific risk. So how many stocks do you need to hold as an individual to achieve maximum diversification and minimise your risk? In reality, it has been proven that you only require between five and 12 stocks in your portfolio.
As a trader, if you are looking to achieve higher returns, you invariably need to take on a higher level of volatility to outperform the market. Therefore you need to hold a smaller number of shares (between five and eight) to actively manage the specific risk. If you are an investor who does not have the time to manage the specific risk, then holding a portfolio of between eight and 12 shares will enable you to reduce volatility without dramatically reducing returns.
Increasing your holdings beyond 12 stocks exposes the portfolio to market risk, which as we have already indicated cannot be eliminated by diversification. This is supported by investors who have been questioning the conventional wisdom of over-diversification, preferring to invest in concentrated portfolios given the average returns achieved by many of the managed funds. The reason for this is that you don’t get twice the benefit from holding 20 stocks than you do from holding 10, and you certainly don’t get 10 times the benefit from holding 100 rather than 10. Given this, it seems unrealistic to justify why anyone would put in the additional time, effort and analysis to find stocks when the diversification benefit is so small.
Obviously if you want to improve the returns you get in your portfolio, it makes sense to simply get rid of the stocks that are going sideways or down. After all, we only want to hold stocks that are rising in price, don’t we? Over the many years I have been supporting traders and investors in the share market, I have seen portfolios constructed with up to 30 stocks or more. And in every case I found a third of the stocks rising, a third going sideways and a third going down with the portfolio achieving at best an average return.
But the bottom line is that if all the client had done was remove the shares that were falling in price, their returns would have been much better. Obviously, this is because the shares falling in value are eroding the gains of the shares rising in price.
This brings me to the second critical area in constructing a portfolio, which is money management. Regardless of whether you consider yourself a trader or investor, money management is critical to your success in achieving good returns on your portfolio. In fact, the two elements of risk and money management work hand in hand.
We know if we put half of our money into one share and the remainder into another seven, then our specific risk will be very high. Therefore to reduce our risk we need to ensure that the amount we invest in each share is no more than 20 per cent. If you are an investor holding between eight and 12 stocks you would invest between eight and 12 per cent of your total portfolio value in each stock.
For example, if you invest eight per cent in each share you will have approximately 12 shares in your portfolio, while if you invest 12 per cent in each share, this allows you to hold eight shares in your portfolio. As a trader, the amount you invest in each share may be greater; although you should never invest more than 20 per cent of your total capital in any one share.
Now that you have a basic framework for how to construct a portfolio, let’s investigate how to select the stocks you should place in your portfolio that will give you a higher chance of being consistently profitable.
The list of shares you select for your portfolio will depend on the time you have available, your resources and the goal of your portfolio. That said, for the vast majority of Australians I recommend not straying too far outside the top 150 stocks on the Australian market for the following reasons:
- They are all profitable businesses with some of the best managers in Australia
- The stocks are purchased heavily by the institutions
- They generally pay good dividend yields
- Reliable information about these stocks is much easier to obtain
- The chances of any one of these companies going broke is very small
- Over a 10 year period these stocks will produce very good returns
Unfortunately, many newcomers to the share market mistakenly believe that investing in blue chip stocks is too expensive and that buying cheap stocks is the best method for achieving higher returns. But this belief not only costs you money, it hinders your ability to generate profits because you are investing your faith in speculative stocks. In other words, you are speculating that a ‘cheap’ stock will outperform a solid blue chip stock, whereas in reality the opposite is true.
The fact is you want to buy quality stocks, not quantity because this is were you will get the greatest gains at the lowest risk. Furthermore, it has been proven that concentrated portfolios perform far better and provide lower levels of risk. Therefore when constructing your portfolio you should look to hold between five and 12 shares and only invest in the top shares on the Australian market. If you take this low risk methodical approach to investing over the long term then, 9 times out of 10 you will achieve far higher returns than if you try and beat the market averages by picking the next boom stock.