An Easy Way to Create a Portfolio

In the last two months, we have gone through the process of selecting value stocks and the basic psychology of investing. If you haven’t had the chance to read those posts, I strongly encourage you to do so before reading this post. We should always try to walk before we run =)

In this post, we shall discuss about creating a portfolio. This is crucial to any investors because a portfolio will determine the kind of expected returns and the level of risk you face. For example, if you choose a portfolio that is full of “blue chip” stocks, you will generally expect lower returns compared to a portfolio of growth stocks. However, a portfolio of “blue chip” stocks will also likely have lower risk as they are generally less volatile than growth stocks. It is always a balance of risk and reward when investing.

Types of Portfolio

There are countless types of portfolio. You can have a 100% equity based portfolio or even a 100% commodities based portfolio or anything in between them. I will touch on 3 types of portfolio that I think is suitable for individual investors like us and I personally adopt one of them as my own portfolio (can you guess which one I adopt? Correct answer gets a reward!) .

Stock-Based Portfolio

This type of portfolio is mostly, if not, 100% on the common stocks in the stock market. This is suitable for people who want to select individual stocks and form their own unique portfolio. Most investment gurus adopt this type of portfolio in an attempt to beat market returns. They do extensive research on individual companies and select the “cream of the crop” to be in their portfolio. Depending on the investment amount, an individual investor may have 10-30 stocks in their stock-based portfolio. I personally will not recommend more than 30 unless you are very well-versed in analysing companies and have the time to do so.

Fund-Based Portfolio

This type of portfolio is also known as the “Do-It-For- Me” portfolio. Investors who do not want to select their own stocks and don’t mind paying a fee for others to select stock for them, may consider this portfolio. In the past, the type of funds available for investors are unit trust and mutual funds which are actively managed by fund managers. However, these funds usually come with a steep management fee, ranging from 0.5% to 3%. However, there is a new kid on the block – Exchange Traded Funds. I mentioned briefly about ETF in another post. Basically, it is a fund that is traded in the stock market like a common stock however it tracks a particular index. For example, the SPDR^® Straits Times Index ETF tracks the performance of the Straits Times Index , while the  SPDR^® S&P 500^® ETF tracks the performance of the S&P 500^® Index which consists of the 500 largest US listed companies. The good news is we can invest in both of these ETFs through the local stock market (check that your stock brokerage firm allows you to invest in ETF too!)

Blended Portfolio

This type of portfolio is a blend of stock-based and fund-based portfolio. This allows the investors to select individual stocks while tapping on the benefits of an ETF (e.g. low cost and diversification). For example, we could invest in 50% of our portfolio in individual stocks to tap on the growth or value of each companies and invest the remaining 50% in an ETF such as  SPDR^® S&P 500^® ETF to seek returns of the overall US market which helps to diversify the portfolio too.

Features of a Portfolio

After we have decided on the type of portfolio that we want, we must decide on three important features to increase our chances of future success in investing.

1. Rules. This is the first and most important feature of a portfolio. We must form a set of rules to govern our way of investing. This is to ensure that we invest consistently and are unaffected by noise or emotions. For example, I spoke about rules in selecting value stocks. We can based on that set of rules to select which stock or ETFs to include in our portfolio. If any stock doesn’t meet the rules, chuck it away. Never, and I say it once more, never bend the rules to include a stock that you “like”. Just because you like Apple and use Apple products daily, it doesn’t make Apple stock a good fit for your portfolio. You must always check their financial and business first. I will talk about the danger of such behaviours in future post.
2. Allocation. The allocation between stocks and funds in your portfolio largely depends on your acceptable risk level and approach towards investing. There is no hard science to this so I will go through a few examples to illustrate it. For example, if we wish to create a stock-based portfolio of 20 individual stocks, we can allocate 5% of the overall portfolio to each stock. This will spread our risk evenly across all 20 stocks however it also averages out any returns across all 20 stocks too. In short, if a stock collapse, we will only lose 5% but if a stock were to double up, our portfolio will only gain 5% too. In the case of a blended portfolio, we could allocate 80% of our portfolio to an ETF to invest in the overall stock market and seek market-level returns. The remaining 20% could be invested in individual stocks if we are beginning with value investing and want to hone our skills further. Allocating just 20% to individual stocks will protect the majority of my portfolio while I still stand to gain from selecting individual stocks.
3. Rebalancing. After we have allocated the portfolio accordingly, it is important to rebalance the portfolio periodically. This is to ensure that our portfolio is not overly weighted in certain stocks or funds. For example in a $100 portfolio that is evenly distributed across 10 stocks, if Stock ABC’s price doubles up from $10 to $20 over a year while the rest of the stocks remained the same, Stock ABC will now represent 18% of your total portfolio ($20/$110). Therefore, we should rebalance our portfolio by selling some of Stock ABC to return the percentage of Stock ABC in our portfolio to 10% again. This will prevent any severe drop in Stock ABC from affecting the portfolio too much. It also cultivates the behaviour of “taking money off the table” when you are gaining in your portfolio. I personally rebalance yearly because I am lazy that way and I don’t want to incur too much transaction cost.

Regardless of the type of portfolio, the three features of Rules, Allocation and Rebalancing will ensure a consistent performance of your investment. In the stock market, consistency is most desired. If the success of a portfolio cannot be replicated, it is likely a fluke, an outlier. We want to perform consistently in the stock market so that we can gain meaningful returns over time.

I hope you enjoyed this post as much as I enjoyed writing it! Leave a comment below if you have any questions or face any difficulties. I would love to help. Otherwise, just introduce yourself and say hi! Do join us at our Facebook group too. We don’t bite, I promise!

Also let me know what you would like the next topic to be? I’m always looking for new ideas.

See you soon!

Investing Always,

Pete

Please refer to the disclaimer here