Friday, 18 December 2009

How to construct a stock portfolio – do’s & don’ts

How to construct a stock portfolio – do’s & don’ts
Thu Jun 4, 2009 1:33pm

Constructing and managing a stock portfolio is hard. Just ask any professional fund manager. So, what should retail investors keep in mind when it comes to their stock portfolio?

First of all, retail investors must recognize that they are competing against the pros. Therefore, you should not do this if you do not have the time or resources to match the research and analytics done by the pros.

Secondly, you must have an investing philosophy that guides you irrespective of the prevailing market conditions. Recognize whether
  • you are a day trader, punting on every rumour that you come across, or
  • if you are a value investor who buys and holds for at least a minimum of 4-5 years.
If you stick to your investment philosophy then you will be disciplined to look at investment opportunities in a consistent way.

Thirdly, understand your risk profile. Are you risk averse? Or are you willing to take on extra risk in order to earn higher returns? High returns aren’t possible without taking on additional risk, and you might not be comfortable with too much risk. Your portfolio should match your risk profile.

Finally, what are you doing towards risk management? This is where the pros really stand out because they understand that managing a portfolio is all about risk management on a daily basis.
  • When the price moves higher or lower than your expectation, do you buy more or do you start selling?
  • Do you recognize that your exposure to one sector or stock might have gone up or down a lot due to market price changes?

Here are some steps that retail investors must take when constructing a stock portfolio?

1) Diversify: Just buying stocks in 1 or 2 companies is not enough. You could be taking on too much risk through a concentrated portfolio, akin to putting all your eggs in one basket. Ideally, your portfolio should have no more than 20-25 names. However, this also does not mean that you can have just say 5 shares of one company and 2 shares of another, because that is all you can afford because you can’t create wealth through just purchasing a handful of shares in a company.

2) Review Your Exposure Frequently: While one investment strategy is to buy and hold, that does not imply that you do not manage your exposure by ignoring your portfolio. Market prices move, sometimes dramatically. As a result, you might have too much or too little exposure to one sector or stock. Get into the discipline of reviewing your exposure regularly, especially during dramatic market movements.

3) Create your own set of rules to guide you: Formulate your own rules for when to buy or sell a stock. Don’t just follow the herd or come under peer pressure. What is good for others might not be suitable for you or your portfolio because your risk, investment criteria, tax situation and entry price might be different.

4)Keep some cash available: Again this is one area where the pros stand out. They recognize that good investment opportunities come unannounced, but in order to take advantage of them they need to have cash available to make these investments. So make sure that you keep some cash available in your portfolio to pounce on these ideas.

If the above sounds challenging and tough for you to follow, then a do-it-yourself portfolio management is not recommended. As an alternative you might be better off investing in the markets through mutual funds, where you can take advantage of the resources and risk management skills of the pros, rather than compete against them.

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