knowledge about How to Build a Stock Portfolio probably as important as stock analysis on one’s own. Although the former I find more challenging.
A portfolio that may seem suitable to me may not work for someone else. but there are few Basic Rules To build a stock portfolio. Anyone can apply these rules and create a customized portfolio for themselves.
In this article, I’ll write about those basic rules. These are the rules I have grasped through reading and applying to build my stock portfolio.
good vs. bad stock
Of all the stocks selected for their portfolio, only 60% will perform as intended. So if some stocks are not performing well then it is acceptable.
But what differentiates good investors and others is the ratio of money stashed in good (60%) versus other stocks (40%). Achievers weigh in the heavy towards 60%.
So even when adding stocks to a portfolio, good investors divide them into two categories, 60%-group vs 40%-group. Depending on the opportunity available, more money should flow into the stocks in the 60%-group than in the 40%-group.
What are good stocks?
What Makes a Stock Good? The following three factors together can make a stock great:
- wide thickOne of the first determinants of a profitable portfolio: wide gap stock. These are shares of big companies. What makes these companies great are the quality products, market share, management quality, brand value, etc.
- margin of safety: If we buy a stock at a discounted price less than its intrinsic value, we retain a margin of safety. Generally, good stocks trade at higher price levels. So buying a good stock at a discount is like holding a plane before take-off.
- hold for long term: The return generated by a stock portfolio also depends on the holding time. Stocks of great companies tend to generate higher profits over time. Why does this happen? it is caused by power of compounding.
The combination of the above three factors can make a stock portfolio unreliable. A wide-gap stock, which is bought at a lower price and held for a longer period, will yield higher returns.
What if good stocks are not available?
Build cash reserves. If pro investors are not investing, they are hoarding cash to provide them when investment opportunities arise.
There will be instances where one may not get opportunities to buy a stock. There can be two cases:
- the investor is Not able to identify company with wide gap. people who don’t know how to analyze stocks A good part can never be found. This is a limit. Such people can learn the process fundamental analysis Of shares. If they have time, they can use a shortcut – my stock analysis worksheet.
- Stocks are available on more valuable price level. First, buy only undervalued stocks. Second, collect stock while maintaining a margin of safety. These two by-laws make stock buying a rare activity even for experts.
So it means that most of the time experts sit idle and do nothing. Why? Because the chance to buy good shares is rarely available. So what do these people do in their spare time?
Warren Buffett says that he spends most of his time reading the annual reports of companies. This is their way of identifying stocks with a wide gap.
There is another thing that happens automatically during idle time (non-investment period). What is this? accumulation of cash. I allow my addition to be deposited using recurring deposit.
Miscellaneous and non-diversity risk
It is not advisable to invest all your money in one company. Similarly, one should also avoid keeping shares of multiple companies in one’s stock portfolio.
We should spread our money in multiple stocks (companies). it will reduce risk of loss.
But there is a limit to risk mitigation. Broadly speaking, there are two types of risks while opting for stock investment:
- miscellaneous risk: This is the risk of loss associated with the company. If the company suffers a loss, its share price will also suffer. Such risk can be mitigated by including multiple stocks in our portfolio. it is called investment diversification.
- non-miscellaneous risk: This is the risk of loss due to reasons not due to a company. Examples of this can be bad economy, slowdown in the sector etc. Such factors affect all the businesses under its purview. For example, a year-2008-09 like a global financial crisis Will affect all companies around the world.
what does this mean? Out of the total risk associated with stock investment, we can manage only miscellaneous risk.
So, how many stocks should be included in the portfolio to get a good diversification? The more the better? Not necessary.
Maximum number of stocks in a stock portfolio
It is only possible to manage miscellaneous risk. Even the number 1,000 stocks in a portfolio will not reduce non-diversified risk. So we should not waste our efforts trying to eliminate non-diversified risk.
So, how many stocks to incorporate to reduce diversified risk? The limit should be around 15 stocks. Why?
To understand this we have to look at it from two perspectives
- potential return, and
- Portfolio Management Rules.
Why limit the stock to a maximum number of 15? The more stocks a portfolio has, the better its diversification. This is true. But in this case, the returns generated by the portfolio will only match the market average (eg 12% per annum). Equal returns are possible by investing passively Index-Based Mutual Funds or else Exchange Traded Fund (ETF). But if one wants to earn returns above the market average, then only a focused portfolio will help.
Experts believe that 90 per cent diversification benefit can be achieved with only 15 stocks. Furthermore, holding too many shares in the portfolio poses a practical problem. how? Too many stocks means less time for individual companies. When we hold stocks in a portfolio, we must read the news, quarterly performance and annual reports related to them. If there are many stocks, it means that we are practicing only shallow investing.
In such a situation, a better option would be to keep stocks indirectly through mutual funds.
If one wants to build a stock portfolio for oneself, it is important to invest within one’s capacity. Owning too much stock is a sign of stock ownership beyond this circle. It’s very risky.
Weighting of individual stocks in a portfolio
One step is to limit a portfolio to about 15 number of stocks. But it is equally important to know how much weighting should be put on individual stocks. From what I’ve read about portfolios, I’m not sure if there are any rules. So I will speak from what I have learned from practice.
Ideally, we should be putting more weight in stocks that are more likely to perform well in the future. how to do this?
When I analyze my stocks, I do several things at a time. First I get a first impression of the company. I my. use stock analysis worksheet. It estimates the intrinsic value, converts it to a . gives overall rating And also produces a 10-year snapshot of it. It gives me a general feel about a stock’s strengths and weaknesses.
Once I get impressed with the stock, I start reading all the news about the company for at least 6-7 days. Once I saturate myself with it, I download its latest annual report and read at least the first 30 pages.
After doing this exercise, I try to make an assumption about the company and its stock. I try to classify them in the 60%-group or 40%-group. If the stock falls in the 60%-group, I start buying its stock. Sometimes, I can charge at least Rs 5,000 per . I start with Business. But I ensure that the weight of the stock does not exceed 5% of the total size of the portfolio. For the shares falling under the 40%-group, I ensure that their percentage does not exceed 1% till I change my perception about them.
Buy less, sell even less
You have already seen the definition of good stock.
“These are wide-gap stocks, bought at discounted price levels, and held for very long periods.”
In such a situation, the long term scope can also be of 15-20 years. So you can see, the holding time is very long. When the holding time is so long, people don’t seem to be selling their holdings. As Warren Buffett says, buy a stock to keep it forever.
In addition, wide-mouth stocks are rarely available at discounted price levels. Therefore, the buying opportunity for the investors is also less. During this time of inactivity, make sure to build your cash reserves.
It is difficult to buy companies with a wide gap. So, once we include them in our portfolio, we should not think of making profits too soon. Why? Because we might never get a second chance to buy such a wide gap at those price levels again.
building a circle of competence
All great long-term investors have their preferences and biases towards certain sectors and companies. Sure, they like these companies, and that’s why they buy and hold their shares.
For people like us, it is more important to know what makes a company like a great investor. Generally speaking, great investors will only buy stocks of companies with the widest gap. We already know this, don’t we?
But identifying a company with a wide gap is not easy. There is no magic formula to tell us that a company has a wide moat. only we can Estimate their gap based on assumptions.
But big investors like Warren Buffett have a better strategy. They form a ‘circle of competence’ about a sector/company. It is nothing but a process of developing a deeper understanding. how to do this? By reading more about the company. Content like news, annual reports, quarterly reports and expert analysis.
When I was in the job, I mainly worked in the steel and power sector. So, compared to other industries, I have a better view of the steel and power sector. So, if I try to scope my potential in these two areas, it will be better.
By doing the same type of exercise, one can expand one’s range of competence in other areas.
Why create a circle of competence? Because the larger our range of capacity, we will be able to locate more broad-based stocks.
Why only stocks? Can we include mutual funds in the portfolio?
Taking recourse to mutual funds can be a good strategy. Generally, the scope of a person’s potential is limited to certain areas only. But it is only natural to be tempted to buy stocks from sectors outside our range of capability. how to do this? We can invest in such stocks through Sector Mutual Funds.
Suppose we are in India, and we want buy stocks of companies in usa. In such a situation, we can take the help of mutual funds to buy those shares.
Building a stock portfolio that complements the strategy described above will generate returns above the market average.
Remember to create a circle of sufficient capacity to hold 15 stocks in the portfolio. Be sure to buy them while maintaining a margin of safety.
If one wants to diversify beyond one’s “circle of ability”, then including mutual funds would be a good idea.
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