The ‘art’ of profitable portfolio construction – Part 2

In Part 1 of my series on profitable portfolio construction I discussed the two critical elements you must always consider when building a successful portfolio. In case you missed it the two elements are:

1. Managing risk, and

2. Money management.

Part 1 focused on managing risk and more specifically on how, as an investor, you must contend with differing inherent risk factors in the market. If you haven’t already, I encourage you to go back and read Part 1 before you read this week’s article, so you have the full gambit of information under your belt.

Before we get stuck into Part 2, I have an important warning. Don’t underestimate the importance of good money management. One of the biggest mistakes I see traders and investors make is to implement a process of poor money management. Mistakes such as allocating larger amounts of your capital into one stock more than others, or speculating on ‘cheap’ stocks, are a recipe for disaster.

There really is an ‘art’ to good money management. Let me explain.

We know that if we put half of our money into one share and the remainder into another seven, then our specific risk will be very high. Therefore to reduce our risk we need to ensure that the amount we invest in each share is no more than 20 per cent of total capital. If you are an investor holding between eight and 12 stocks, you would invest between 8 and 12 per cent of your total portfolio value in each stock.

For example, if you invest 8 per cent in each share you will have approximately 12 shares in your portfolio, while if you invest 12 per cent in each share, this allows you to hold eight shares in your portfolio. As a trader, the amount you invest in each share might be greater (given traders normally only hold around five or six stocks); although you should never invest more than 20 per cent of your total capital in any one share.

Now that you have a basic framework for how to construct a portfolio, let’s investigate how to select the stocks you should place in your portfolio that will give you a higher chance of being consistently profitable.

The list of shares you select for your portfolio will depend on the time you have available, your resources and the goal of your portfolio. That said, for the vast majority of Australians I recommend not straying too far outside the top 150 stocks on the Australian market for the following reasons:

• The stocks are highly liquid

• They are all profitable businesses with some of the best managers in Australia

• The stocks are purchased heavily by the institutions

• They generally pay good dividend yields

• Reliable information about these stocks is much easier to obtain

• The chances of any one of these companies going broke is very small

• Over a 10-year period these stocks will produce very good returns

Unfortunately, many newcomers to the sharemarket mistakenly believe that investing in blue chip stocks is too expensive and that buying cheap stocks is the best method for achieving higher returns. But this belief not only costs you money, it hinders your ability to generate profits because you are investing your faith in speculative stocks. In other words, you are speculating that a ‘cheap’ stock will outperform a solid blue chip stock, whereas in reality the opposite is generally true.

The fact is you want to buy quality stocks not quantity, because this is where you will get the greatest gains at the lowest risk. Furthermore, it has been proven that concentrated portfolios perform far better and provide lower levels of risk. Therefore, when constructing your portfolio you should look to hold between five and 12 shares, and only invest in the top shares on the Australian market. If you take this low-risk methodical approach to investing over the long term then, nine times out of 10, you will achieve far higher returns than if you try and beat the market averages by picking the next boom stock.