The ultimate Q&A to Stock Portfolio 101
Investing tips 05: This post covers my responses on constructing and managing a stock portfolio that has been collated from my Quora responses. I have updated it to provide some stock portfolio concepts. Revision date: 22 Dec 2021
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| “The single greatest edge an investor can have is a long-term orientation.” Seth Klarman |
An investment plan is your strategy to invest your money. It should outline what you are planning to use the money for, how long you are willing to leave it invested, and what assets you put your money into to achieve your goals.
The most diversified investment plan is one that takes a global perspective. If you accept this logic, then you should adopt a 2-tiered investment plan.
- How to allocate your overall net worth to several asset classes.
- Then within each asset class, you spread the money to different items. For example, you could be looking at how to allocate between various stocks to form a stock portfolio.
The goal of asset allocation (or portfolio plan) is of course risk protection since you don’t know how the future will turn out. You spread your bets to several assets (or items within a portfolio) so that one or two failures do not wipe you out.
This post focuses on questions relating to stock portfolios with answers from the view of a bottom-up, stock-picking, long-term value investor.
It is part of a series meant for newbies. I am coming from the perspective that you are interested to learn how to invest based on fundamentals. This requires you eventually to analyze and value companies.
If you don't want to do this, but still want to invest based on fundamentals, there are many third-party advisers who can do this for you. A good example is Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.
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Contents
1. Why have a stock portfolio?
2. How to construct a stock portfolio
3. When to Buy or Sell
4. Portfolio management - returns and growing wealth
1. Why have a stock portfolio?
If you know that a particular stock is going to give the best return in the future, you would be an idiot not to put all your money into this one stock.
The reality is that we cannot foresee the future and we don’t know which stock will perform. So, we spread our money to several stocks. We diversify thereby establishing a stock portfolio.
The idea behind diversification is that if one stock does badly, we hope that the others will do well enough to offset the one that did badly.
Having a diversified stock portfolio then is about risk management. However, this post is not an introduction to Modern Portfolio Theory (MPT). Harry Markowitz published this theory in the Journal of Finance in 1952. He was later awarded a Nobel Prize for his work on MPT.
MPT is a theory on how investors can construct portfolios to maximize expected return based on a given level of market risk. MPT can also be used to construct a portfolio that minimizes risk for a given level of expected return.
MPT is based on the view of risk as volatility. Since I do not follow the volatility school, I had to look at portfolio construction and maintenance differently.
Irrespective of how you view risk, a stock portfolio is about diversification so that you have a balance between risk and returns.
1.1 How does one create an investment plan and how much should be in stocks?
If you look at the goal of investment as protecting your savings against the ravages of inflation, then an investment plan is nothing more than how you allocate your savings to various asset classes to do this. Hopefully, you make more to grow wealth at the same time.
Then within each asset class, you also spread your investments to several items. For example, I have several categories of value stocks - turnaround, Graham Net Net, and dividend king.
If you can foresee the future, you will certainly put all of your savings into the asset which gives the best return. Unfortunately, in real life, you don’t know which assets will do the best in the future. So, you spread your investments. You also don’t know what emergencies you will face that require some cash.
The best investment plan is one that covers emergencies, performs well in all economic situations, and gives you some comfort of mind.
That is why I think a person should have at least 3 asset classes or buckets:
- Bucket 1 - Liquid assets to cover emergencies. I have 2 years annual expenditure saved with the bank. The logic is that you are then not forced to sell the risky assets at the wrong time to cover the emergencies.
- Bucket 2 - Safe assets ie those that protect the principal. These are generally govt bonds. I have 8 years of annual expenditure here. The logic is that if I lose all the risky assets, I have this as the “floor” net worth. Of course, these assets don’t correlate with the risky ones so it serves as some risk mitigation measure as well.
- Bucket 3 - The balance is in risky assets. These are stocks and properties as in Malaysia these two give the better returns.
The rationale is that the stock market is a long-term investment and very volatile in the short term. The cash is to ensure that you do not have to sell at the wrong time to meet emergencies.
Also, the 10 years of cash and bonds are to ensure that I can ride out a bad business cycle (which I assumed to be 8 to 10 years). The 10 years of cash and bonds will also provide better returns in economic situations when the stock market does badly.
If you don't have enough to fill up bucket 2, you should not be investing in any risky assets.
If you look at these from the economic scenario perspectives, I like Ray Dalio’s idea of ensuring that the overall portfolio will do well in the 4 major economic situations - formed by the combination of inflation vs deflation and economic growth vs depression.
Furthermore, for each of the risky assets, you should have a risk mitigation plan. I like to think that I have one so that in the worst-case scenario I will not lose more than 30% of my original investment.
So, to come back to the question of how one creates an investment plan:
- The goal is to protect against inflation and hopefully grow wealth.
- Spread it among several asset classes so that it serves two main purposes.
- Cover emergencies and have a floor to give you peace of mind.
- Overall, it performs well in all 4 economic situations.
The amount for emergencies and the floor net worth will depend on individual needs and will probably change over time. It is about risk management.
But my point is that if the asset allocation is about risk mitigation, then you should take it to the logical conclusion and ensure that you have an overall risk mitigation plan.
You can do this by adopting a host of measures for your investment plan where asset allocation is just one of the many measures.
1.2 What are some examples of portfolio investment diversification?
There are more than a dozen different asset class - stocks, bonds, options, properties, currencies, futures, etc
When you ask about diversifying are you talking about going into different asset classes?
Or are you talking about diversifying into different types within the same asset class eg in stocks you could be into small caps, large caps, or you could be diversifying internationally?
I am going to deduce that you are asking the question because you are a beginner in investing.
If what I deduce is true, you should go one step back and first learn a bit more about investing. When you have this basic knowledge, the answers become self-evident
1.3 How much money should I have before I start investing my 10-20% on stocks?
Most asset allocation advice is for spreading your money into 3 groups or buckets. If you follow this 3 buckets plan, you will know what should be allocated to stocks. Refer to Question 1.
There are also other rules of thumb that have been developed to help you determine what to set aside for stocks based mainly on your risk tolerance and age eg
- The 60:40 rule.
- The age formula.
- The all-weather strategy.
Personally, I think it makes more sense to cover the emergency fund first, and then any balance should start with an equal amount to the safe and risky assets (stocks).
As your net worth grows, you probably reach a stage where you cap the amount on safe assets so that more could be set aside for risky assets.
My personal cap is 8 years of annual expenditure on the ground that it allows me time to ride any business cycle affecting my risky asset. But then I am the risk-averse type.
At the same time, I think the advice on linking the ratio to age is misleading. It should not be age but rather whether you have the income to add to your net worth or whether you are withdrawing from your net worth.
If you are still at a stage of having other income to add to the net worth then could have a bigger ratio of risky assets. But if you no longer have any income, then you probably have a smaller ratio of risky assets.
2. How to construct a stock portfolio
There are a number of key questions when it comes to constructing the stock portfolio:
- How do you select the stocks?
- How many stocks should you have?
- How much to invest in each stock?
How do you select the stocks?
There are 2 ways to form the stock portfolio.
- Top-down - this involves looking at big picture economic factors. A top-down approach is a macro approach. In many ways, it is a continuation of the asset allocation process. It examines various economic factors to see how they affect individual stocks.
- Bottom-up - this involves looking at company-specific factors. In the bottom-up approach, you try to identify specific companies based on your investment criteria. You build up the stock portfolio one by one based on the appropriate selection criteria. For example, if you are a value investor, then you select the stocks whose prices < intrinsic values.
How many stocks should you have in the portfolio?
By adding stocks to a portfolio that are not correlated with stocks already held, you can reduce the portfolio risk. Studies have shown that the benefits of adding stocks to a portfolio decrease with the size of the stock portfolio.
However, the studies are not very conclusive. There are proponents for both ends of the concentrated vs diversified spectrum. The general view is that the benefits of diversification become marginal once you go beyond 30 uncorrelated stocks.
The nature of market sentiments is such that sectors tend to be correlated and it would be a challenge to find 10 to 20 uncorrelated stocks. Given this, then you may need to identify 30 to 40 stocks and then adopt a different set of measures to minimize the correlation.
What I have done is to have a number of diversification factors or criteria. I then assessed the degree of concentration under various criteria. Some of the criteria that I have used are:
- Sectors or industry.
- Market cap or size.
- Business performance or Investment type - turnaround, compounders, cyclical, dividends.
- Regions or countries.
The idea is to select stocks based on different factors. My rules of thumb for diversification are:
- Single stock concentration - the market value of a stock should not be more than 10% of the market value of the total portfolio.
- Group concentration - the market value of a group of stocks for a particular factor should not be more than 30% of the market value of the total portfolio.
How was the 10% or 30 % determined? The 10% represents the total amount I was prepared to lose in one stock. The amount would vary with the risk tolerance of an individual. Similarly the 30% represents what I was prepared to loose for a particular group of stocks.
How much to invest in each stock?
There is a relationship between the 3 key parameters of a portfolio.
- The total amount to be invested for the portfolio.
- The number of stocks in the portfolio.
- The amount to be allocated to each stock i.e. the position size.
Assuming that there are 30 to 40 stocks in the portfolio, then the average amount invested in each stock will range from 2.5 % to 3.3 % of the total portfolio value. Of course, if the amount for each stock is not the same, then the range would be wider.
2.1 For a portfolio consisting only of stocks, what are some good allocation strategies?
When it comes to stocks the goal of the portfolio is diversification. Target about 30 companies so that they represent different sectors, different market caps, and different investment styles.
By style, I mean value vs growth, or dividend vs non-dividend payers, those turnarounds vs those with strong moats, etc.
You slice and dice the portfolio in different ways so that you are not concentrated in one particular style.
I am assuming of course that the 30 companies you selected are the ones with the best conviction.
2.2 If you had to invest 100% of your portfolio into 1 stock, which would it be?
It would be the ETF of my portfolio if there is such a thing.
The reason for having a portfolio of stocks is risk mitigation. So, unless you have a way to guarantee the performance of a particular stock, you should diversify.
The only people who bet on one stock is the owner entrepreneur when they first start out.
But if you are a normal investor, you should invest in more than one stock because unlike the entrepreneur-investor above, you are not driving the company. You don't have control over the future of the companies you invest in.
2.3 How do I perform position sizing while buying stocks?
If you are a trader, position size can be determined by the amount you are prepared to risk per trade (eg 2 to 5 % of the money allocated for trading) and the price fluctuation range.
But if you are a long-term investor, I have not been able to use the trading concept to determine the position size.
Generally, the position size is dependent on both the amount of money allocated for the whole portfolio and the number of stocks to be held. For example, if you have $ 100 and you want to hold 20 stocks, then if you hold an equal amount of each stock, you would have $ 5 per stock.
What determines how many stocks? And do you allocate the same $ to each stock?
If you want a diversified portfolio, academic research suggests that you should hold at least 20 stocks of different sectors, sizes, etc. The goal is to have as low the number of stocks yet be diversified to maximize your $ return.
So, you have one way to determine the number of stocks to hold. if you settle for say 25 stocks, then how do you determine the amount for each stock?
The idea is to allocate the largest amount to the stocks that you have the highest conviction. “Conviction” here could be those with the best margin of safety, those with a “steady” future, etc. This is based on the idea behind the Kelly formula.
Note that you cannot apply the Kelly formula literally as the probability of getting the return is not constant.
To simplify matters I categorize the stocks into 3 groups and allocate them on a group basis eg Group 1 is $ X, Group 2 is $ 1.5 X and Group 3 is $ 2 X so that the total adds up to the money allocated for investment in stocks.
You see that there is no simple answer given that position sizing is only one of the several factors to consider when investing.
3. When to Buy or Sell
There are 2 common investing styles:
- Buy and sell pieces of paper. This is a market-sentiments driven strategy. You chase after the popular stocks as you believe that this will drive price higher. Some use charts and other technical indicator to help then gauge market behaviour.
- Buy and sell part-ownership of businesses. You look for opportunities where the market price is selling less than the value of the business as determined by its fundamentals. You believe that the market price eventually follows the business value.
It is obvious that the buying and selling signals will depend on your investing styles:
- For those investing based on market sentiments, you buy if the indicators suggest that the price is going up. You sell when the indicators suggest a market top.
- For those investing based on fundamentals, buy when you find undervalued stocks and sell when the stocks become overvalued
It is obvious that it would take some time to establish a stock portfolio. This is because it is unlikely that you will find the 30 or 40 stocks with the same buying signal at the same time.
3.1 Is it better to buy 1 share of a 500 dollars stock or buy 500 of 1 dollar share?
If you are a value investor, it makes no difference as the value is the same. But if you are a speculator, you may think:
- If I buy the $500 stock, the company may split the shares and I could make some money as values do go up after the split.
- If I buy the $1 stock, there is more liquidity and hence more will speculate. Or people will consider this a penny stock and speculate
Unfortunately, I am not a speculator so I am stuck like you on what to do.
3.2 How often do you purchase stock? And how do you decide which stock to get?
Which stocks you invest in depends on which investing school you follow. For example, if you invest in dividend stocks then you look for those that match the criteria. If you are a value investor then you look for stocks selling at a discount to the intrinsic value.
Similarly, the frequency of your purchase is dependent on your investment philosophy.
People have been successful with different investing schools and styles. It really does not matter as long as you become an expert in a particular school/ style and stick to it.
3.3 What are some stocks in your portfolio that you never sell?
Even a “permanent stock” holder like Buffett sells.
There are 2 views of growing your investment
- Have a fantastic portfolio where the companies continue to increase their business values forever. If you have this, there is no reason to sell.
- Have a portfolio where when some stocks' prices exceed their intrinsic values, you sell to invest in other undervalued ones. You do this because you do not think you have any forever growth stock in your market.
Unfortunately, I am in the market where I see lots of Kodak, GE, or Dell equivalents. So, I don't have stocks I never sell. But I do have stocks that I have waited for 10 years for the market to rerate.
If you are buying stocks with a view to making money, then you should sell when:
a) the price has reached its intrinsic value
b) the price and dividends you received are significantly more than what you could have made from bank interest. My target is 10% per year compounded.
So, you see that the criterion is not the length of time. Having said this, it will probably take several years to achieve the above.
Of course, you sell immediately if you found out that you made a mistake in your analysis and/or valuation of the stock.
3.4 In what stock investment situations does "averaging down" make sense?
Averaging down refers to the situation where after you have invested one share at $X per share, the price went down to say $0.5X per share. You then buy another share so that your average price becomes $0.75X.
This only makes sense if the intrinsic value of the investment is more than $X per share. Technically you are buying more of the bargain.
Note that I differentiate between intrinsic value and price. The intrinsic value does not depend on price although the price may be influenced by the intrinsic value.
I think averaging down is a misleading term as it gives the impression that it is a clever thing to do.
Now imagine a situation where the intrinsic value is $0.4 per share and you made the mistake of buying it initially at $X. Why would you want to buy another share at $X0.5? You are merely increasing your loss.
The point is not to focus on the average cost. Focus on the average “bargain”.
4. Portfolio management - returns and growing wealth
Once you have constructed the stock portfolio, you then have to maintain it. There are several questions that come to mind as you manage the portfolio.
- How do you grow wealth with the stock portfolio?
- What do you do with the dividends you receive?
- How do you assess the portfolio performance when you put in more funds?
As you can see managing a stock portfolio is an ongoing process.
You grow wealth through the power of compounding. This requires you to have consistent returns over decades of investing. Basically, once you sell one stock, you reinvest all the proceeds into other stocks. This applies irrespective of whether you are buying and selling pieces of paper or part-ownership of companies.
If you have a long-term investment horizon, it if likely that you will be receiving dividends. The rule is that you also invest all the dividends.
There is a difference between measuring the returns of a stock and measuring the returns of a portfolio. In the case of a single stock, the total gain = capital gain + dividends. The return is then the total gain divided by the original investment sum. You can then use this concept to compute the simple annualized return or the compounded growth rate.
When it comes to the stock portfolio, the return for the portfolio is complicated by the following situations:
- During the period, some of the stocks could be losing money. You could have a negative total gain if there is a capital loss that is larger than the dividends.
- You could have sold off some stocks and be holding cash. Alternatively, you could be holding onto some dividends in cash form rather than have them reinvested during the review time.
- You could have also have allocated additional funds to the portfolio. In other words, the portfolio is bigger not because of any gain, but because of additional funds.
To cater to such situations, I define the total gain and return from a stock portfolio in the following manner.
- Total Gain for the portfolio = current value - previous value + dividends + any uninvested money.
- The portfolio returns for the period = gain divided by the previous portfolio value.
I used the market value of the stocks in the portfolio to calculate the portfolio value. It is the sum of the market value of the respective stocks. The current and previous values refer to the value of the portfolio assuming it is liquidated.
The market value of a particular stock = number of shares held X market price. The number of shares held currently may be different from the number of shares held before. This could be due to bonus issues and or other corporate activities.
To ensure that I am comparing apple to apple, I also include any dividends or money that I have received that has not been reinvested.
- The dividends refer to all the dividends paid during the measurement period. Since there is a likelihood that you may reinvest the dividends, I look at the after-tax value of the dividends received.
- The money could be money pending reinvestment or also be money taken out.
The above is of course just the gist of managing a stock portfolio. If you want to know more about returns and growing wealth refer to the following:
- The ultimate look at how to get rich from the stock market - you have to subscribe to the blog to get this free guide.
4.1 How long do you allow a stock price to drop before you sell it as a loss?
If you are a value investor and have bought the stock based on a discount to its intrinsic value, you should not sell if the intrinsic value is still intact.
But sell if the intrinsic value has fallen below the price.
So you see that if you are a value investor, your buying and selling signals are not dependent on the price movement per se. You should have a long-term outlook and ignore paper losses due to daily price movements.
FYI, due to Covid-19 most of my stocks are down 30% to 40 % from my purchase price. But I have re-looked at my valuations and believe that the intrinsic values are still far above my purchase price. So, I am sitting tight.
But to be able to do this, before you invest, you must have a way to allocate your savings so that only a certain % is allocated to stocks. I follow the 3 buckets strategy (Refer to Question 1). The 3 buckets' strategy is to enable you to ride out the market downturn so that you do not crystalize the paper loss into an actual loss.
This is not the first time I have experienced this 40 % drop. It happened in 2008 during the financial crisis and in 1997 during the Asian economic crisis. Both times the market came back and went higher. You need the holding power.
You have to ask yourself why you are thinking of selling.
- If it is because you need the cash, then you need to think about your asset allocation strategy before you invest further.
- If it is because you did not have a value investment basis to buy the stocks, you may have to rethink your investment style.
- If it is because you merely speculated, then cut loss.
4.2 Reinvestment options: a) do you take dividends as cash or automatic reinvestment? b) Do you sell if it passes a 5% loss and buy it back later when it shows signs of recovery?
With regards to (a), you take cash if you think you can invest in some other stocks that give better returns. However, if you want to buy the same stock as with the dividend reinvestment plan, then the automatic re-investments (at least for Bursa Malaysia) are generally at a discount to the current market price.
As for (b), I think you have to ask yourself whether you are a trader or investor.
Your question is probably something that a stock trader might do. A trader by definition buys and sells based on price signals.
On the other hand, if you are a value investor, you buy when the stocks are at a significant discount (> 30%) to their intrinsic values. And you don't worry about the price fluctuations after you have bought as long as the intrinsic value is intact.
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