How to Build a Stock Portfolio – A 4-Step Guide
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Investing is a complicated business. There are stocks, exchange-traded funds, mutual funds, bonds, cryptocurrencies, and fixed income products to choose from. While you are looking to make low-risk investments and bag high returns, you also need to ensure that you are building a solid portfolio.
One of the most preferred ways of making money is through the stock market. The volatility of the market can make you rich over time and this begs the question: Is it worth taking the time and effort to build a stock portfolio?
There are many benefits of having a stock portfolio and if you are willing to do the homework to understand the industry and the individual company, it will pay off in the long term. In this guide, I'll take you through the steps to build, achieve and balance your stock portfolio.
In this article
Step 1: Your goals and asset allocation
Have a clear picture
Before you start on the investing journey, you need to have a clear picture of what you aim to achieve. Ascertain your financial situation and investment goals before you start allocation. You need to have a time frame over which you expect the returns. If you want to build a solid stock portfolio, you need to start with a minimum period of five years in mind. However, the payoff period could also be longer if you are starting in a bull market. Investors who want quick returns can consider trading in cash or derivatives. Another factor you need to consider is the return expectations.
You want returns that are higher than those paid by traditional banks on your savings account. But you also want low risk and minimal monitoring. If you are a beginner and want stable returns without any research and time, you can consider investing in mutual funds. But if you want to have a hands-on approach to investing, ascertain the expected returns you want and look for stocks that will match them. Further, consider your risk tolerance and decide if you are willing to take a potential loss of some money for high returns. All of us want high returns but if the investment doesn’t let you sleep at night, it is not worth it. Do not eliminate the risk so much as you optimize it for your situation and lifestyle. Your age and current income will also impact this decision.
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Have a plan
If you look at the price movement of stocks over the last 20 years, you will realize the importance of investing for long-term growth. Take an example of Microsoft stock. It has gone from $50 in 2000 to $284 today, excluding the dividends. Even Starbucks stock has gained 73 fold in the last two decades. The stock was down significantly 15 percent of the time but this does not speak about the entire history of the company.
You must remember that the value of your portfolio will fluctuate but you need to develop an investment strategy that allows you to keep your conviction even in times of market volatility. Part of this view is to invest in stocks you believe in when the prices are falling. While investing in dividend stocks can earn you a steady income but you need to focus on the potential of capital gains. It is ideal to have an asset allocation that is 60% growth stocks, 20% exchange-traded funds (ETFs) and 10% dividend stocks, and 10% speculative stocks.
Have an investment horizon
It is essential to have a time frame in mind when building a stock portfolio. If you are investing in individual stocks, you need at least five years to generate returns on them. The longer, the better. If you are investing with a specific goal in mind, you need to remain invested until your goal looks achievable and if you are investing for retirement, you will need a pretty long investment period.
Step 2: Building the portfolio
Do your homework
Building an investment portfolio will need research and time. There is a lot of free educational information available for all investors and the resources on the subject of stock investing has grown over the last few years. That said, there are tough regulations on the financial disclosure and information by the management which means you have a more level playing field when it comes to research and access to materials. Since the information is easily available today, the only price of building a solid stock portfolio is your time.
Related: Best Stocks to Buy for Beginners
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Choose the right parameters when picking stocks
After choosing the right investment account for your portfolio, you need to consider certain parameters when stock picking. The company should have a strong leadership and management team with a solid track record. Secondly, the company should have a portfolio of products or services that appeal to its customer base, and third, it should be making a unique product or service that allows high-profit margins. When you build a stock portfolio with the hot picks but they do not fit the parameters mentioned here, you will end up paying a heavy price for this decision. The companies that have solid leadership and a diversified portfolio of products that appeal to the customers can become the pillars of your portfolio and help beat the market in the long term.
Pick a strategy and style
When you decide to build a stock portfolio, do not make the mistake of believing that everything will lead to big money. Avoid accumulating the stocks based on recommendations, no matter where you get them from. When you do not have the clarity in methodology, style, or strategy, you will end up with a portfolio that neither contains risks nor delivers on returns.
Fundamental or technical analysis: You need to make a call if you want to follow technical analysis or fundamental analysis. Both strategies can be used to identify stocks. All fundamental investors believe that there is a chance to build wealth by identifying the misplaced businesses, which can compound earnings with time. In contrast, technical investors focus their attention on the historical price movement of the stock and believe that anything worth knowing about the stock is in its price. Such investors will buy stock based on when the trend is bullish.
Though there is no hard and fast rule, if you are looking for a longer horizon, you need to follow fundamental analysis and if you have a short-term horizon, you need to follow technical analysis. Seasoned investors tend to use fundamentals when identifying the stock to buy and then use technical analysis to decide when to buy.
Value or growth style: Another choice you need to make is between value investing and growth investing. Value investing is all about buying businesses that are trading at a discount to the fair value while growth investing is about buying businesses that have the potential for high growth and there is less weightage given to the valuations. There is no right or wrong here. Both the styles outperform at different points in time and one cannot accurately identify which style will win. It is best to have a mix of growth and value stocks in the portfolio.
Watchlist approach: In order to ensure that your stock portfolio has prime businesses, you need to take a watchlist approach. You will find good businesses that you understand and like to own even at pricey valuations. So, instead of going after the unaffordable prices, simply put the stock on a personal wish list and track it closely. You can then use an event-triggered correction in the stock to get your hands on it at an attractive price.
Be picky
Always use your research to identify the companies that you do not like in the long run or that have lost money over time due to the lack of differentiation and the rising competition. The airline industry is a good example. It has lost a significant amount of money since its inception and you will not be able to make solid long-term returns on it even if you manage to pick the best operator. It helps to understand the economics that plays behind a business.
You must learn the impact of demand and supply on the stock price so as to understand the prospects of the industry better. For some products, the rise in price will not immediately lead to a drop in demand. For example, the price of a consumer staple rising will have an impact on the demand because there are several other alternatives to choose from. However, if the price of gas goes up, the demand will not drop because people need to drive and there are fewer alternatives available today. Hence, when choosing companies to invest in, be picky and understand the product or services they sell.
Step 3: Achieving the portfolio
Diversification is the key
It is important for every investor to diversify their stock holdings. There are various stock sectors classified by S&P Dow Jones indices and these include consumer staples, financials, energy, information technology, industrials, telecommunication services, consumer discretionary, materials, utilities, and healthcare. It is best to own two to three of the best companies in each sector. This will ensure that whenever a sector is down, the other sector is making you money. If you invest all your money in a particular sector, you will end up with huge losses in case the sector is down. You can use stock screeners and rankings to identify the best stocks for your needs. Investing research should not be limited to hedge fund analysts or fund managers and can work for you too.
There is another way to diversify, you can invest between value stocks and growth stocks or between dividend stocks and value stocks. This is a great way to reduce risk without lowering the expected return on the portfolio and it will ensure that the winners compensate for the losers.
Besides protecting you from the possibility of going wrong with the stock choices, diversification of your portfolio will also help smooth out the returns. Your portfolio should have assets with negative or low correlation with one another. This is why different sectors make the most sense. Strive for a balanced portfolio of companies that have domestic and global revenues and can handle the volatile cycles.
You must also have pre-decided weights between the small-cap stocks, mid-cap stocks, and large-cap stocks. Most of the large-cap stocks will have low volatility as compared to the small caps and the mid-caps. However, remaining market capitalization agnostic is not a bad idea either. Several mid-cap companies are market leaders and have consistent margins. They could be better than large-cap firms. But research remains crucial.
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Look closely at the stock weights
Whenever you take a research-based approach to stock selection, you will get lucky with at least a few stocks that turn multi-baggers over the years. But if you want to make regret-free investment decisions, you need to use a position sizing strategy based on your risk tolerance and then decide on the stock weights. Access the overall value of your portfolio you are willing to lose in each trade you make. It could be 1% to 5% and you can follow this approach to set up the equal weight in your portfolio.
You can decide the weights based on the historical risk-reward characteristics of the stock. So if you want low risk and moderate return portfolio, you can have higher weights in the stocks with low volatility and lower weights in those with high volatility. But if you have a better understanding of the business, you can also have higher weights in stocks owing to reasonable valuations. It helps to have anywhere between 15 to 30 stocks in the portfolio and a weight of 3% per stock. When buying in the bull market, start small and add to the position as you build conviction in the valuation.
Step 4: Rebalancing the portfolio
After you have an established portfolio, it is important to analyze and rebalance it regularly because any changes in price will cause the initial weights to change. Another reason you need to rebalance the portfolio is the change in your financial situation, risk appetite, and future needs. If the risk tolerance has dipped, you need to reduce the number of stocks held. But if you are ready to take high-risk now, you can look for the more volatile stock investments. When rebalancing, identify the positions that are overweight and underweight and reduce or allocate accordingly. If you think that the portfolio is overweight, you need to sell the stocks and buy underweighted stocks. Also, have an outlook for the securities. So, if you think that the growth stocks might fall in the near term, you might want to sell them. You can seek the help of a financial advisor if you are unable to rebalance the portfolio by yourself.
Although it is not possible to time the stock market, the timing of your entry into the stock market is crucial and will decide how smooth your journey will be. Investors who had bought during the lows in 2020 have made solid returns over the two years. While those who entered the market in 2008 have had subpar returns even with the best stocks. This shows the importance of the right timing and having a cash component in the portfolio. When you have enough cash in your portfolio, you will be able to take the plunge when the prices are correct. It will also help grab the watchlist stocks in case of a price correction.
The bottom line
Building a stock portfolio is only the beginning. However, a dedicated and interested investor can enjoy payoffs that can be worth the time and research. You will need to understand the parameters of the stock and spend time on research. Choose from one of the many tools at your fingertips to make the right decisions, there are several resources for educational purposes including stock newsletters, stock screeners as well as brokerage firm research.
You must continue to research and review in order to ensure that the stocks in your portfolio are in alignment with your financial goals. Ultimately, you want to build a portfolio that beats the market and you have to be willing to put in the work and time. You must also be willing to hold the portfolio for the long run, even if the price does not go your way for a while.
Besides the stock market, there are other asset classes you may want to consider for long-term investing. This includes real estate, mutual funds, bonds, and ETFs. Understand the different types of investments and consider how they help achieve your personal finance goals. Not all assets will be suitable for your portfolio but with the right investment advice, you can build a stellar portfolio over time.
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Editor
Vandita Jadeja is a financial writer and editor at Joywallet. She loves to read and write about money and brings a decade of experience from the financial industry.
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