Sunday, November 22nd, 2009
How to Build a Quality Portfolio
Portfolio management is an often overlooked but extremely important aspect of both investing and trading. A well-constructed portfolio can help reduce risk, smooth returns, and build wealth over time. Keeping this in mind, this article will outline some key ways in which individual investors can build a diversified portfolio of stocks to maximize their returns.
The Importance of Diversification
Diversification is one of the most important aspects of portfolio management, and can help reduce risk and build wealth over time. However, many investors still do not properly diversify their portfolio, particularly those that hold a large amount of stock from their employer. Others are not sure how many stocks they should own or how to go about diversifying.
Here are answers to some key questions:
- How many stocks should I own? Mathematics has shown that the benefits of diversification begin to level off at around 15 stocks, meaning that anything beyond this number may begin to cost more in commissions than benefit from diversification.
- What kinds of stocks should I buy? One of the most important things to remember when diversifying is to purchase stocks in a variety of industries and in a variety of sizes. So, it is wise to pick one stock from various industries, ranging from small cap to large cap.
- How much money do I need? The importance of diversification comes regardless of trading capital, but investors should invest at least $500 per stock in order to avoid excessive commissions.
- Should I buy bonds or keep cash? Bonds and cash can help maintain a healthy balance if the stock market in general declines. Most experts recommend having about 20% of your portfolio in cash or bonds, but this number should increase with age to lower risk.
Determining and Calculating Risk
In the stock market, risk is equal to volatility, and volatility is measured with what’s known as a beta coefficient. Essentially, the beta coefficient measures the variance of a given stock from the market’s normal variance. A reading of 1.0 indicates that a stock is just as risky as the market average, while lower indicates less risk and higher indicates more risk.
Investors building a portfolio should make sure that their portfolio’s risk is in line with their investment objectives. Here are a few key points:
- Children and Teens. Children and teens that plan on holding stocks for decades may want to consider keeping a portfolio of higher risk stocks in order to maximize their returns, since near-term volatility doesn’t make that much difference if they are not selling.
- Mid-life Adults. Mid-life adults that plan on holding stocks for at least a decade before selling may want to keep their risk profile roughly in line with the market.
- Older or Retiring Individuals. Those looking to retire in the near-term will want to keep a lower risk profile, since they are likely to be selling relatively soon.
Investors can calculate their portfolio’s beta coefficient by taking the weighted average of the coefficients within their portfolio. Meanwhile, investors should select stocks with an appropriate beta coefficient when adding stocks to their portfolio.
Key Points to Remember
- Investors can minimize risk and maximize returns by diversifying their portfolio and adhering to proper risk management.
- A good portfolio holds 15 or so stocks in various industries with an average beta coefficient that is aligned with an investor’s objectives.
Written by Simon Monger
