Once you are ready to start investing, building your own portfolio should be on the agenda.
It goes without saying that owning more than one stock is a priority as diversification is key for reducing risk and protecting your investments.
If an investor doesn’t diversify well enough, significant sums of money can be lost as significant market movements take hold.
Buying enough stocks can be expensive, particularly when transaction fees can push your investments into negative positions immediately.
For example, if you were to invest with $1000 for every investment, 1% would be lost immediately through the $10 transaction fee.
If you have to pay stamp duty or fees for currency exchange, the situation could be worse with an immediate loss of 3% or 4%.
If a stock returns 10% a year, you can see that your returns can be significantly reduced through the associated costs of investing.
Having the right expectations and setting up a portfolio to suit your budget is key to making successful investments.
A commonly held perspective in the finance industry is that you should own around 30 stocks in order to be diversified enough.
This ideology came from two finance academics, Fisher and Lorie, who found in their 1970 research that if investors held 32 stocks, they could reduce risk to the same amounting as investing in the whole market (100+ stocks).
If investors picked stocks that performed better than the whole market, they could then have a better return without taking on much more risk.
There are many limitations to their findings but it is true that the more stocks you own, the more similar your returns will be to the overall market.
This should be obvious because if you buy more stocks then you logically own more of the market. Therefore, the risk profile of your portfolio becomes increasingly more similar to the overall market.
The reality is, there is a relationship between risk and reward. If an investor takes more risk, then the bigger rewards they should expect to receive. At the same, investors that take bigger risks should accept that the investments that they make are more likely to fail.
In short, there’s not exactly a specific number of stocks that you should own. Fisher and Lorie’s 32 stock portfolio is used widely in the finance industry, though there are limitations that we will cover in the future.
The more stocks you own, the less risk you will be exposed to. With less risk, lower returns should be expected.
A few lessons ago, we talked about the differing characteristics of stocks. Those characteristics are highly important to consider when building a portfolio.
Smaller companies are more risky than large companies, therefore it is common for an investor to mostly in large companies, with a smaller percentage of their portfolio being investing into small companies.
Small companies, often referred to as ‘penny stocks’, typically have very low stock prices that make them seem very cheap on paper. I’ve met many new investors that say that they are going to buy 500 small companies with $1 each, hoping that one of them becomes the next Amazon or Google.
That way they’ll make enormous returns from a small investment.
I admire their logic but in practice, it is a totally ridiculous idea.
The reason is simple.
Remember that the transaction fee on stocks is around $10 per trade. If an investor put $1 into 500 small companies, it would actually cost him $5,000 in transaction fees, while the investment would be worth just $500. So in total, the idea would cost $5,500.
Sure, if one or two of them blew up it could be a fantastic idea, but making more than $5,500 from just $1 would be nothing short of a miracle.
This idea is not only expensive, but it is incredibly risky.
Aside from the size of a firm, it goes without saying that the stage of development should be considered. Investing in startups or in companies that past maturity is very risky. The more appropriate strategy is to invest in growth or mature companies.
The sectors that stocks operate in should also be considered. Investing in too many companies that operate in the same field will result in very similar performance.
Investing in companies from a range of different sectors is advisable.
A growing theme in this lesson is the cost of investment, which is an important consideration if investors have smaller amounts of money.
If you were to follow the 32 stock portfolio perspective from Fisher & Lorie, it would cost $320 in transaction fees alone, without even thinking about potential currency exchange fees or tax liabilities.
To actually make it worthwhile, you’d probably have to invest something like $1000 per stock, which would obviously cost $32,000 in total.
With that in mind, it’s important to say that it depends on the price of a single stock. Sometimes stock prices are above $1000, like Amazon ($3300), Google ($1750) or Berkshire Hathaway ($300,000).
Many investors don’t have that kind of money and may feel that they are very limited in what they can do in the market.
For that reason, the finance industry (Jack Bogle specifically) created an instrument called an index fund.
We’ve talked previously about what index funds are, so you should know that they are funds made up of every stock in a stock market index (e.g. FTSE100).
Index funds are usually very cheap to invest in as they have low prices and cheap transaction fees. You can usually find a fund that cost around $1 to buy into, while $1.50 is the standard transaction fee in the UK.
Therefore, you could invest as little as $10 and it would cost you just $1.50. Making such a small investment is necessarily advisable as $1.50 is 15% of $10 – which would take at least a year or two to get back.
However, if you were investing something like $100, it would be more worthwhile. With a transaction fee of just $1.50, you can see that index funds are much more affordable than buying individual stocks.
When you buy an index fund, you are also buying 100s of stock in one go so the diversification is very high.
For example, with the S&P500, you are essentially buying the 500 largest companies in America. With the FTSE100, you are basically investing into the top 100 companies in the UK.
Therefore, index funds are absolutely the best choice for investors with small amounts of money.
If you are investing in individual stocks, it’s really important to review the performance of your portfolio every year.
It’s not always necessary to make significant changes if the performance has been mediocre, especially if you have invested for the long term and have bought specific stocks with a specific reason in mind.
With that said, revewing the performance of your portfolio once a year gives you the opportunity to assess each stock and to decide whether you would prefer to make changes or not.
Sometimes major changes can happen within a company that can change the attractiveness of the investment.
For example, if the CEO changes and the new leader wants to make drastic changes that may harm the business, it could be reasonable to sell the position.
In order to know if you have picked bad stocks or if there’s something fundamentally wrong with your portfolio, it’s best to compare your returns with the returns of a benchmark.
Investors usually use an index fund as a benchmark that they are trying to beat. If their portfolio has performed woefully compared with a particular index, the investor will make changes.
For example, an American investor may build a portfolio of 20 American stocks. He may then decide to use the S&P500 as a benchmark to assess the performance of his portfolio.
Investors are always trying to outperform their benchmark.