Portfolio

What is 'Portfolio'?

A Portfolio in general means a collection. A group of something and such. In the Stock Market, your collection of the total investment can be referred to as the Portfolio. But more commonly the collection or the group of invested stocks by you is called as your 'Portfolio'. Your portfolio could consist of a single stock up to a maximum decided by you.

How to manage your 'Portfolio'?

Portfolio management simply refers to the process of making decisions as to the appropriate investment mix, the potential performance of the investments, managing risks and meeting your investment objectives. 

Diversification

The main problem with any type of investment is the certain degree of 'risk' associated with it. Risk could be either favorable or unfavorable outcomes that were not foreseen. There's NO term called 'ZERO RISK', because that is practically unavoidable not to face a risk. But there is a term called 'minimizing risk' or 'managing risk', because that is practically possible. So how to minimize the risk of your overall investment? One word answer. 'Diversification'. Diversification in simple means investing in more than one or two stocks. A more advanced explanation would be, a risk management technique that utilizes a mix of investments in your portfolio. 

Let's see how Diversification reduces the risk of the investment. This could be quoted with a popular proverb, "don't put all your eggs in one basket". If you drop the basket by mistake all the eggs are gone. But if you had the eggs in two baskets and if one basket falls and breaks all the eggs, there's still the other basket with a bunch of saved eggs. If you understand this story, you've understood what diversification is really about. It' that simple. But most of us tend to neglect the small facts and go for big calculations, predictions, equations and stuff. But sticking to the basics will not fail you at all.

So it is said that you should diversify your portfolio in order to minimize your risk. Say you have 10 stocks and if five of them go down, there's still hope with the rest five stocks. With diversified portfolio it's very hard to loose the whole game. But if you have just merely a stock or two your chances of failing are pretty high. Investing is a lesser number of stocks is called as 'Under Diversification'.

Over Diversification

This is the other extreme of diversification. Fearing the risk, the investor tends to diversify his portfolio as much as possible. But this is not good at all. Yes, over diversification could bring your risk to a very low level, but the chances of making profits out of these stocks reduce to a great extent. Because of monetary constraints a single stock in an over diversified portfolio will only have a small quantity of shares. Thus it will be very hard to gain a proper profit when all the stock market fees, brokerage fees and other taxes add up to the cost of buying and selling. So it is not advisable to have a HUGE collection of stocks either. The generally accepted number of stocks that should be present in a good portfolio would be 20. But this will vary immensely based on the value of your total investment. But it is advisable that you don't exceed 20 stocks when buying shares. 

(this is not buy/sell/hold recommendation.)

Not getting what you expected from the market?

Read this if your stock-market results are disappointing.

I'm reading a great book that is making me think about how I've been managing my share portfolio, even after several years of stock-market investing.

It's called "Selecting Shares That Perform" and was written by Richard Koch and Leo Gough, one a successful investor and the other a prolific author of financial and investment books.

Some of their rules for portfolio management challenge my previously held views, but I think they make sense. The following list starts with the rules that are rocking me the most:

1. Never 'average down' when the price is falling

They must be joking, right. Never average down; surely that flies in the face of conventional wisdom. Heck, I've averaged down on my investments loads of times, when they've moved against me.

But here's the thing -- although times of general market weakness may be a good time for bargain hunting, maybe there's a rational argument for not averaging down when an individual investment tanks. What we are talking about here are shares that fall despite being part of a rising index or portfolio. After all, we buy shares in companies because our analysis leads us to think that they will go up. If they go down, we were wrong, plain and simple.

Averaging down means we think a share is about to turn around and go up again, right? Well that's a tough call to make and one that's easy to get wrong. If you don't believe me, look at shares such as Royal Bank of Scotland (LSE: RBS), Lloyds Banking (LSE: LLOY) and Taylor Wimpey (LSE: TW), all popular 'value' favourites around 2007. Look at the share prices of these companies now and think of those investors that averaged down into the share-price destruction.

To me, it seems wise either to maintain our original weightings in such bad performing investments, or even to consider using the next rule:

2. Never be afraid to sell at a loss

Instead of averaging down, why not axe a falling share? I mean, it's doing the exact opposite to what it was 'supposed' to do, so why not just cut and run after a predetermined decline? The book I'm reading suggests 7-10%.

I wish I'd done that much more often. Shares such as Trinity Mirror (LSE: TNI), Dixons (LSE: DXNS) and HMV (LSE: HMV) could have been prevented from causing so much private-investor carnage if those punters had simply sold on share-price weakness.

3. Balance patience and prudence

Whether we fall into the 'long-term buy and hold' camp or the 'it's never wrong to take a profit' camp, it's a good idea to seek a balance between the two philosophies.

How patient should we be? If we are holding a share for years, and nothing happens, maybe it would be more prudent to sell and move on to other opportunities. Similarly, if a share rockets very quickly, maybe it's prudent to pocket some of those gains. My own rule-of-thumb is 'the faster the gain, the faster the sale.'

Generally, I think it's wise to be flexible and not become too entrenched in either philosophy.

4. Do not over-diversify your portfolio

Traditionally, a diversified portfolio of shares is seen as a defence against individual company risk, but too many shares in a portfolio can actually increase risk.

With too many shares, it's hard to know the underlying companies that well. There is a risk that the quality of your choices might decline and, with so many holdings, you could end up chucking in a few speculative punts with hardly any thought.

With greater focus on just a few shares, it's more likely that we will be on the ball when it comes to buying and selling. The book suggests that between five and ten shares is adequate for most investors.

5. Do not invest heavily when everyone else is

You've probably heard the adage: "When they are crying, it's time for buying; when they are yelling, it's time for selling."

In other words, when everyone has gone share crazy, there's a good chance that markets may be close to a cyclical high -- often a disastrous time to buy most shares.

Conversely, when markets have plummeted and shares are very unpopular due to recent investor losses, it is usually a good time to pick up cheap shares on depressed valuations.

6. Only invest if you are confident in the company's prospects

The book cautions: "Investing in the stock market is not like picking a winner at Aintree", and we can only be confident in a company's prospects if we have researched and analysed it thoroughly.

If we invest in speculative companies with no profits, but with great 'potential,' it is usually very similar to betting on the horses with an unpredictable outcome. On the other hand, finding attractively valued, profit-making businesses with good growth prospects can help us to achieve results that are more predictable.

Bottom Line

To me, these are sensible rules and I'm looking forward particularly to applying the first two more with my own share portfolio.

Published in Investing on 19 August 2011 by Kevin Godbold