It’s all very well finding individual companies to invest in, but you also need to know how to build a strong stock portfolio that can work together and potentially become greater than the sum of its parts.
First off, let’s start by saying there is no definitively correct way of building a stock portfolio.
Like many things in investing, you often need to take the time to see what works for you and to find what you feel comfortable with so that you’re not tempted to sell out at just the wrong moment when times get tough.
How to build a strong portfolio of team players
Here are some guidelines you can follow when building a strong stock portfolio.
The overarching principle is that you want a mix of different types of businesses that will help smooth out the ups and downs that the stock market naturally experiences on a regular basis.
As the old saying goes, you don’t want to put all your eggs in one basket!
You could compare a stock portfolio to a top-performing football team. You need a healthy mix of attackers, playmakers, defenders, and a goalkeeper in order to give the team the right sort of balance. If you’re weak in or over-dependent on one area, the team might struggle.
A strong stock portfolio operates in a similar fashion. Some players might work well together while others won’t gel at all. But you might not find that out until they’ve played a few games. You might want to make some changes and some players will inevitably get injured because of factors beyond your control.
Let’s move on as we’ve tortured this analogy quite enough!
It can also help to think of your stock portfolio as a whole rather than obsessing about the performance of the individual stocks within it.
Certain types of company move in and out of fashion all the time, and there will always be stocks you own that are going through difficult patches — that’s just the nature of business.
In fact, the idea of some businesses doing well while others struggle is kind of the point of having a portfolio in the first place. Its main purpose is to smooth out those sorts of ups and downs.
If everything in your stock portfolio is moving in the same direction at the same time, then that’s a pretty good indication that you are not that well diversified!
What is the ideal number of stocks to have in a portfolio?
Lots of studies have investigated how many shares you need in a strong stock portfolio in order to become well diversified. Unfortunately, they all seem to come up with a slightly different answer.
Most seem to settle in the range of 20-30 companies but some people suggest that there is not much diversification benefit once you reach as little as 12-15 stocks.
The overall size of your stock portfolio needs considering, too. If you are just getting started and have a few thousand pounds or less, then owning fewer companies probably makes more sense. You can always add further positions in future.
Understanding the ideal number of stocks to have in a portfolio
Own too few companies and you are likely to either do very well or very poorly. If you have a five-stock portfolio and one of the businesses you own runs into serious trouble then you could be down 20% overall.
Therefore, if you have a smaller number of positions, you should be prepared to watch them more closely.
The problem with owning large numbers of companies is that you’ll have less time to research them and follow their progress (however, that’s where our Share Advisor service can help out!)
You might end up putting money into ideas that you have less conviction in. The performance of your stock portfolio may end up being not that different from the overall market.
The ideal number of stocks will likely vary for different people and some folks may find their ideal number changes over time.
For example, in their younger days, with more time to invest and a greater appetite for risk, they may be happy with a few stocks. As they grow older and become more risk averse, wishing to keep what they already have, a larger number of stocks might seem more appropriate.
How to build a portfolio over time
There’s no need to buy a complete portfolio on the first day you become an investor. In other words, don’t feel you need to rush in and buy everything at once.
In practice, you might want to assemble your initial portfolio over a couple of years, learning as you go and picking up new opportunities as they present themselves.
One popular technique is to buy a small stake in a company you’re interested in and to follow it for a while. As you get to know the business better and what drives it, you can build up your position to a more significant size.
Another consideration is how much money you expect to add to your portfolio in future. If you are regularly adding new money then you’ll need to put this to work, either buying brand-new positions or adding to existing ones.
You also need to consider what to do with those investments that don’t seem to be working out. Many people end up with a long tail of small positions and keeping track of these can be time-consuming. You might want to consider whether you’ll just let these positions ride or whether you’ll regularly clean them up and reinvest the money elsewhere.
Many investors like to keep an investing journal, writing down why they decided to buy a particular share. This can help you later as you can then see if the original reasons you had for owning a stock still apply.
How to build a strong portfolio that’s well diversified
You’ll find that some companies are very sensitive to the economic cycle of boom and bust (often called cyclical stocks) while others tend to be much less volatile (called defensive stocks).
Cyclical stocks are companies like house builders and banks, who will often see their profits fall sharply or even make losses when the economy struggles, while defensive stocks include big consumer brand companies and utilities.
It makes sense to have a good mixture of the two types, otherwise many of your shares will lurch in the same direction at once. And while it might be tempting to think you can load up on cyclical stocks just before the economy starts to improve and ditch them at the first sign of a recession, timing the market in this way is a lot more difficult than you might think!
It can also help to have a mixture of large companies (i.e. those in the FTSE 100 index), medium-sized (valued at, say, £500m to £2bn) and smaller ones (valued at £500m or less). You may well find that at certain times large companies are in favour while at other times it’s smaller ones. So again, mixing things up can help smooth out your returns.
One thing worth avoiding is picking a lot of shares from the same industry sector. Many investors fall into this trap, especially when a particular industry becomes the next “hot” thing. But individual sectors can fall in and out of fashion very quickly, and you can easily become unstuck if you have the majority of your cash in just one or two types of business.
How to build a stock portfolio with non-UK shares
A lot of companies sell their products and services all around the world.
In fact, it’s reckoned about 70% of sales made by FTSE 100 companies are to outside the UK. Some people think this means there is little need to invest in non-UK companies.
However, UK companies only make up around 5%% by value of all the world’s listed stocks.
What’s more, the UK market is concentrated on a few sectors like banks and other financial services, energy, and mining. That means keeping your focus exclusively on UK-quoted shares can mean you’re ignoring many great stocks, most notably those in the technology sector.
It’s become a lot easier to buy and sell overseas companies in recent years. And a lot cheaper, too. There’s little to stand in the way of any investor who wants to add a number of non-UK stocks to their portfolio.
Another alternative is to look at funds or trackers that invest in non-UK shares. These can help you to quickly build up a decent position size in a broad spread of companies. Over time, as you become a more confident investor, you could then add some of your favourite overseas stocks as well.
How to build a strong portfolio of winners
Here at The Motley Fool we’re very much long-term holders of shares. We want to own businesses for years, if not decades, so we don’t like to chop and change all the time, second guessing what share prices will do next because of macro-economic factors.
There’s good evidence to suggest that investors who trade more frequently perform worse, partly because they rack up more in charges.
However, very often you might find that after a little time has passed a few of your shares will do very well, most of them will be middling and doing the same as the overall market, and you’ll have a few big losers.
Your previously strongly built portfolio could start to look a little unbalanced and be overly concentrated in just a few shares.
Exactly what level “overly concentrated” is, though, is again a matter of personal preference.
Some people will start to feel queasy with more than 5% in a single share, while others will be happy with 10%, or even 15%. It depends on what sort of a company it is as well. If the company concerned is very speculative, then a little additional caution might be advisable!
In order to rebalance your stock portfolio a little, you could continue to add more cash over time, or you could sell some of your largest holdings and invest in other shares instead.
At The Motley Fool, we generally believe that winning shares will tend to keep on winning. After all, their share prices have probably done well because their underlying business has performed well. This means we might look to add to other positions where the business has done well but where its share price hasn’t grown quite as quickly.
What to do with losing positions is another difficult area for investors.
Some people advocate getting rid of shares that fall in price, regardless of how the underlying business is performing. We tend to think differently, and generally we’re happy to keep hold of companies that continue to do the right things on an operational level and where the long-term story still looks intact.
One particular trap to avoid is thinking you need to get back to break-even on every individual share that you hold. It can hurt to take a loss, but often it can be the right strategy to invest your money elsewhere, if the reasons you bought the share for in the first place no longer apply.
A stock portfolio is simply a collection of investments in different companies. The basic idea is to have a mix of company sizes, industries, and geographies so that - taken together - they form a more resilient whole. For example, a portfolio that just consisted of oil shares would be very exposed to movements in the oil price.
What makes a good stock portfolio is very subjective but we’d say it’s one that is well diversified and therefore not overexposed to one or a few types of company or trends. It will likely consist of a dozen to a few dozen individual companies, with no single position being significantly larger than the rest.
A stock portfolio is a collection of individual stocks that are designed to complement each other or that concentrate on a few key themes. So you could think about things like how many different companies you want to own, how much to invest in each position, what sort of industries they operate in, what geographies they cover, what customers they serve and so on.
A stock portfolio works by reducing the overall risk you face when investing in a single company. By choosing different types of company and putting them together, your overall portfolio should be less vulnerable to changes in economic trends and other factors that can affect a single company’s profits, financial position or share price.