Portfolio management is about weighing up risks and returns, diversifying our holdings and considering overall portfolio performance.
Portfolio management is also about the ongoing monitoring of the stocks you own, and determining when to sell stocks.
Portfolio management theory
You can perform a very thorough analysis of a stock. The prospects for the industry may be great, the company might be in a strong financial position, but things can still go wrong. Companies can be involved in legal disputes, key customers can drop off, changes to legislation can have undesirable effects. Bad fortune can strike a company out of the blue.
To compensate for unforeseen circumstances, we need to spread our investment capital amongst a number of stocks. By purchasing a basket of stocks, if one or more don’t live up to our expectations our other stocks will keep the boat afloat.
Not only should we buy shares in different companies to spread our risk, but we should also buy stocks in different industries. It can be tempting to fill up your portfolio with mining stocks in the middle of a resource boom but common sense needs to prevail.
It’s a good idea to keep some of your investment capital in cash at all times. That way if the stock market has a correction (a significant fall) then you might be poised to buy shares in great companies at cheap prices.
The portfolio management process
In a nutshell, the portfolio management process involves:
1. Buying stocks
2. Monitoring the stocks you own, and
3. Selling stocks
Buying stocks
Before we buy a stock we look at our current portfolio weightings to determine if we are overweight or underweight in different areas. We want to know:
- How many stocks do I currently own?
- What industry sectors are already represented in my portfolio?
- How much cash do I have tied up in each industry sector?
- What is the total monetary value of my portfolio?
- How much of my investment capital is cash?
- How much cash will I have left in the kitty after I purchase these stocks?
I don’t intend on expanding this any further. I personally don’t set limits such as only investing a certain percentage of my total portfolio capital in any one sector or stock. I believe the most important thing is to exercise some awareness and common sense before adding a stock to your portfolio. You decide which areas of your portfolio need more or less coverage.
When buying stocks it’s a good idea to record the date you purchased the stocks, the quantity you bought, and the stock price you paid. This helps you to keep track of your portfolio.
Monitoring your stocks
A short-term trader will have an obligation to monitor his/her stocks constantly. Their buying and selling is based on short-term information so they need to keep on-the-ball.
The investor on the other hand, is more concerned with medium to long-term information. This means that you only need to monitor your stocks maybe once or twice a week.
So what do we look for when monitoring our stocks?
What do we need to know?
I like to know what the stock price is. Whether it’s trending up, down, or sideways.
What’s happening with the company? We can learn a lot by reading the company announcements. I also like to know if any of the big players (institutions and large investors) are doing any major buying or selling.
I want to know when the next company report is due so I can read it straight away. And depending on the situation, I can see how the market will react to the news as it happens.
When the company presents its annual report, I do a quick analysis of the key financial numbers and ratios (see Key Performance Indicators, Financial Health and Profitability Analysis). I want to know that everything is still looking good.
When to sell stocks
Knowing when to sell a stock is probably the hardest decision an investor will face. So it’s important to establish some guidelines that you can follow.
The guidelines that you set up will have to be aligned with the investment strategy you follow. For instance, the sell signals that a growth investor might act on could be different to the sell signals a value investor reacts to. For the purposes of this lesson, we will only consider value investing.
A value investor might sell a stock if:
- the stop-loss is hit (assuming that you’re using a technical analysis approach to timing your entries and exits)
- their target price is achieved
- the stock price reaches “fair value” (i.e. an intrinsic value calculated during the initial analysis)
- the P/E ratio is getting too high for comfort (meaning that the stock is now overpriced)
- the fundamentals deteriorate (Return on Assets, cash flow from operations, or operating margins deteriorate, or the company takes on more debt than seems reasonable as per the debt-to-equity and interest coverage ratios)
- a value catalyst that you identified earlier does not look like eventuating
- the prospects for the company or industry change significantly
Benjamin Graham said that he would sell his stocks if they rose 50% in value or he’d held them for two years – whatever came first. I don’t follow the 50% principle (not to say that it’s bad idea) but if I buy a stock I expect it to move upwards after owning it for two years. If it hasn’t gone anywhere after two years I usually sell it. After all, I don’t buy stocks with the intention of holding them forever. I want to sell them in one, two or three years. I’m in the business of making money.
When you sell a stock it’s a good idea to record the date you sold the stock, the quantity you sold, and the stock price you sold them for. This is part of your portfolio management. It also helps you when you need to declare your profit or loss when you fill out your tax return.
How many different stocks constitute a well-balanced portfolio?
The law of averages tells us that the more stocks you own, the closer you get to average returns. If we want average returns we can buy into an index fund. For a lot of people that might be a good option. But for people who aspire to greater returns, individual stock selection is the way to go.
A bag of ten to fifteen stocks is adequate for a properly diversified portfolio. Any more than that and you’ll have a hard time keeping track of all your stocks and your returns will move closer to the averages.
The next key question becomes:
How much of my investment capital should I invest in each stock?
How much you invest in a stock depends on the how risky you deem the investment to be. For companies with a higher level of risk, invest a smaller amount. For companies with a lower level of risk, invest a larger amount.
Here’s an example for investors who have $50,000 to invest. You might like to keep $10,000 in cash. Ideally, your cash would be put into a high interest “at call” bank account.
Of the remaining $40,000 you might like to invest $4,000 in ten different companies. $4,000 represents your “middle of the road” position. If a stock is a higher risk company, for instance a speculative miner, you might only invest $2,000. If the company is a robust service company with a number of substantial ongoing maintenance contracts you might invest $4,000 to $6,000.
Your position (a position is a holding in an individual stock) sizes vary according to the risk you associate with each stock.
If I don’t have any investment capital how do I get started?
Okay, so you’re just starting out. Like most people, you don’t have $50,000 to invest. How do you get started? You start small and build up gradually.
You might want to save up $2,000 or $3,000. Buy shares in a company using all of those funds. Then save up another $3,000 and put that money into another company. When you own ten stocks you might want to have a break. Don’t buy any more stocks for a while but keep saving cash. When you’ve saved up $10,000 stop for while.
Why stop? Well you don’t have to. If you want to keep saving and investing that’s up to you. It all depends on your financial circumstances. The main thing is that you build up your share portfolio to a decent size. The larger your portfolio, the quicker it grows.
Share portfolios that are topped up regularly with some savings take on a snowball effect.
Summary Points
- Diversify your portfolio by purchasing ten to fifteen stocks
- Always keep some of your investment capital in cash
- Examine your portfolio before buying more stocks
- Monitor the stocks you own to ensure that they are moving in the right direction
- Sell your stocks when your stop-loss (traders) is hit or the fundamentals deteriorate (for investors not using technical analysis to time buys and sells)
- Keep a record of your buying and selling