The ‘art’ of profitable portfolio construction – Part 1

With the Australian sharemarket booming over the past few months, people are now gaining more confidence about returning to invest in shares. But are they really doing the right thing and constructing a winning portfolio when they return?

The truth is that just about anyone can build their own share portfolio and achieve good returns with only a little bit of knowledge. The key to being successful in the sharemarket is to practise good portfolio management. So how do we do this?

What follows is a practical framework that will allow you to not only construct a profitable portfolio but ensure you only select stocks for your portfolio that have a higher chance of being consistently profitable.

So let’s get started.

There are two critical areas you need to consider when constructing a portfolio:

1. Managing risk, and
2. Money management.

We have all heard that we need to diversify in order to reduce risk, but how many of you actually understand diversification in its true sense? According to the financial services industry, you can achieve greater diversification by investing in managed funds than if you invested directly yourself. But in my experience, managed funds can hold up to 100 different stocks in their portfolio, which not only increases transaction and other costs, but also the risk of the portfolio. Further, it dilutes returns, condemning you to investing mediocrity.

While it is true that diversification reduces risk, a portfolio of shares that is over-diversified is exposed almost exclusively to market risk, which cannot be eliminated by diversification. Let me explain.

Investors who choose to invest in a particular market are exposed to the risks inherent in that market, such as the economic influences of inflation and interest rates that affect the market as a whole. Therefore, the market risk remains regardless the degree of diversification.

However, an investor must also contend with specific risk, which refers to the risks inherent in a company or particular events in a sector that influence specific securities. The total risk, therefore, is the sum of the market risk and the specific risk of the individual positions.

Obviously specific risk is very high if you invest in only one stock, but the more a portfolio is diversified, the less the specific risk. So how many stocks do you need to hold as an individual to achieve maximum diversification and minimise your risk? In reality, it has been proven that you only require between eight and twelve stocks in your portfolio.

If you are an investor who does not have the time to manage the specific risk, then holding a portfolio of between eight and 12 shares will enable you to reduce volatility without dramatically reducing returns. Increasing your holdings beyond 12 stocks exposes the portfolio to market risk, which as we have already indicated cannot be eliminated by diversification.

In simple terms, you don’t get twice the benefit from holding 20 stocks than you do from holding 10, and you certainly don’t get 10 times the benefit from holding 100 rather than 10. Given this, it seems unrealistic to justify why anyone would put in the additional time, effort and analysis to find stocks when the diversification benefit is so small.

If you desire to improve the returns you get in your portfolio, it makes sense to simply get rid of the stocks that are going sideways or down. After all, we only want to hold stocks that are rising in price, don’t we? Over the many years I have been supporting traders and investors in the sharemarket, I have seen portfolios constructed with up to 30 stocks or more. And in every case I found a third of the stocks rising, a third going sideways and a third going down with the portfolio achieving at best an average return.

The bottom line is that if all the client had done was remove the shares falling in price, their returns would have been much better. Obviously, this is because the shares falling in value are eroding the gains of the shares rising in price.

In short, every investor and trader can make better returns from the sharemarket if they understand that:

1. They need to sell, and
2. They need to know when to sell.

This brings me to the second critical area in constructing a portfolio, which is money management. Regardless of whether you consider yourself a trader or investor, money management is critical to your success in achieving good returns on your portfolio. In fact, the two elements of risk and money management work hand in hand.

I will discuss the concept of money management in my next article, until then I suggest you take a look at your portfolio to see if you have too many shares in it.