Good portfolio management is crucial if you want to have any success investing in the stock market. I am going to show you how to create a stocks portfolio, even if you are a total beginner.
Before we start make sure to check the Metrics for any terminology that you might not be familiar with.
Now let’s first start with explaining what actually is a stocks portfolio. That is the total amount of all the shares that you possess. For example here you can check mine to give you an idea.
Now before you start building your portfolio there are some questions that you need to be able to answer.
About You
1. What is Your Risk Tolerance?
This is the most important question that you need to ask yourself before you start building your portfolio. People who are near retirement or do not have high tolerance to risk will want a more conservative portfolio. Younger people generally speaking have higher risk tolerance and can have a riskier portfolio.
The way to moderate the risk is by adding more bonds. The more bonds you have in your portfolio the lower the risk, but the lower the potential returns as well. As a rule of thumb the amount of bonds in your portfolio should equal your age. For example if you are 30 years old your portfolio should consist of 30% bonds and 70% stocks. That is of course not always true, but this is the general idea.
So to summarise – if you want to have less risk add more bonds, if you want more risk and more potential return – add more stocks.
The easiest and safest way to get exposure to bonds is by ETFs. The Vanguard Total Bond Market ETF (BND) is a great way to automatically diversify between all the bonds without the need to know much about them. For example if you want to have 20% bonds just make this ETF 20% of your portfolio. Simple as that.
2. What is Your Time Horizon?
Before your start buying shares you need to ask yourself how long is it going to be before you need your money. If it is less than 3 years there is no point getting into stocks at all. They are volatile and your investment can be down by 50% in the short-run at any given time.
The beauty of it is that the longer you are invested the more money you are going to make because of the power of compounding. Generally speaking you want to invest in the stock market if you have 10 or more years that you wouldn’t need the money.
Now the principle with the time horizon is the same as the risk tolerance. The less time you have the more % bonds you should have in your portfolio and vice-versa.
3. What are Your Strong Points?
There are dozens of different industries and countries in the world and you cannot possibly be qualified to know all of them in detail – no one is. That is why you should focus mostly on the things that you understand. For example if you like video games you should focus on video games stocks, if you work in healthcare- focus on healthcare etc.
That way you are going to have some sort of advantage and more information, making your decisions easier.
4. What are Your Weak Points?
Now as I said no one can possibly know about all the different sectors and countries in the world. But it is important to have some exposure to them for diversification. That is why I like using ETFs in such scenarios. For example you want to have some real estate exposure, but you don’t know much about real estate. In this case you can just buy an ETF like the VNQ for example.
That way you get automatic diversification across the whole real estate sector. Speaking of which we can now go to the next step in your portfolio.
Diversification
This is crucial to understand in order to build a portfolio. But why is diversification important? By doing it you reduce the risk in your portfolio. For example let’s say your portfolio consists of 2 stocks. Each of them is 50% of your portfolio. If one of them goes to 0 you are going to lose 50% of your money. Not a good situation as you can imagine.
Now let’s say you own 20 stocks. Each of them is 5% of your portfolio. If one of them goes to 0 you are now going to lose 5% of your money. Again probably not a great feeling, but much better than losing half of your money. Essentially the more diversified you are the less risk you have.
Now let’s check the different ways to diversify.
1. Asset Class Diversification
It is a good idea to be diversified across different asset classes- stocks, bonds, commodities(gold, silver etc.) and real estate. This is to again reduce the overall risk of your portfolio. For example gold and real estate are going to protect you against inflation, bonds are going to protect you against deflation. This way you are going to be ok no matter of where the market goes.
Of course the allocation is going to be different for different people. For example if you know the real estate market it is a good idea to have the majority of your money there, same for the stock market. If you are more conservative it is a good idea to have a bigger part of your portfolio in bonds.
2. International Diversification
Having all of your money in just one country can be risky, no matter which one. This is why you should have a part of your portfolio in international stocks. A good way to do this is again through ETFs. I personally don’t feel comfortable owning single shares of companies in let’s say Vietnam and that is why I own them through broadly diversified emerging market ETFs.
If you have a good knowledge of certain international market of course it will be a good idea to pick individual stocks. That is in case you know how that given market works, what are the laws in there etc. Investing is a game of information and only put your money somewhere when you have enough information available.
3. Market Cap Diversification
Stocks are divided by market cap and they can be either small-cap, mid-cap or large cap.
- Small-Cap – A company with market capitalisation between £300mln and £2bln
- Mid-Cap – A company with market capitalisation between £2bln and £10bln
- Large-Cap – A company with market capitalisation of over £10bln
As you can probably tell there is a difference in how those companies behave in different market environments. Smaller companies for example have more potential to grow, but are also riskier. Usually they outperform during economic booms, but underperform during recessions. Bigger companies on the other hand are usually growing slower, but are more stable during recessions.
Also smaller companies tend to be more volatile, so if you don’t like big swings in your portfolio you might want to stay away from them. If you can stomach some volatility you can be rewarded with some great returns though.
4. Sector Diversification
As you might know the economy and therefore the stock market are divided into different sectors. There are 11 sectors in total, now let’s take a look at each one of them.
Energy
Consists of oil, gas, coal and fuel companies and also all companies that are creating the infrastructure around them. Here you can see all the companies that are refining, transporting, distributing or creating different sources of energy. Here you can also find all the renewable energy companies. Some examples are Shell, BP or Chevron.
Basic Materials
These are all the companies that produce all the materials for the products that we use. For example plastics, wood, steel, cotton etc. They are at the beginning of the supply chain and they sell their products to other businesses. Such companies are Ecolab and Mosaic for example.
Industrials
This is a very broad and big sector of the economy. It consists of aerospace, defence, manufacturing, construction and airlines. Usually this sector provides a very big % of a country’s GDP and you can see a lot of big companies here. Because of how big it is it is not a bad idea to diversify within the sector and hold more than one company from it. Some examples here are Boeing, Caterpillar or Siemens.
Consumer Discretionary
Here are all the companies that produce the products that we buy that are non-essential to us. Usually the better the economy is the better these companies are doing. These companies are tightly correlated to consumer confidence. If we are worried that we might lose our jobs we are not going to buy a new fancy car or go to a restaurant every day. Examples of some companies here are Ferrari, Nike or Hasbro
Consumer Staples
These are all the companies that produce things which people use on a regular basis. Here are all the food and beverage companies, household goods, everyday care, supermarkets and basically all the things that you buy daily. Examples are Coca-Cola, Kraft-Heinz, Walmart or Tesco.
Healthcare
This sector includes everything related to health – pharmacies, hospitals, healthcare equipment and healthcare services. Some examples here are Walgreens-Boots Alliance, Johnson&Johnson or Bayer.
Financials
This sector is represented by banks, insurance firms and asset management companies. Examples here can be Barclays, Santander or Goldman Sachs.
Information Technology
Here you can find all the tech companies. This is a very broad sector and companies in there include everything from payment processing to semiconductor companies. Examples here would be Microsoft, EA Sports or Mastercard.
Communications
These are all the companies involved in the different methods of communications – phone companies, internet providers, email providers etc. Basically everything that we use to communicate with each other. Some examples here are Vodafone, Facebook or AT&T.
Utilities
This sector consists of your electric, gas and water utilities. They are mostly regional, for example Thames Water for all the water utilities in London or Yorkshire Water for the Yorkshire area.
Real Estate
Here we can see all the real estate developement companies, all the homebuilders as well as all the REITs. Examples of such companies are United Rentals, Toll Brothers or British Land.
How to Diversify?
As you can see there are a lot of different directions you can go in order to diversify. If you want to be properly diversified you might want to have a mixture of different asset classes, different sectors, different market caps and different countries. As investing is a personal thing for every person the level of diversification is going to be different.
For example one person might want to have more international stocks while another might want to have more tech stocks in their portfolio.
What is important to understand is that diversification does not happen overnight and you do not build a portfolio for a day. I like to thing of a portfolio as a living thing, which grows with us and adapts with us. You start by buying your first stock, then you buy another one, then maybe a rental property and so on.
How to Diversify For a Total Beginner?
Now I know that not everyone wants to Research different stocks, follow economic news and so on. If you want to just put your money somewhere and not worry about it I have some good news. You can do that by buying basically 2 ETFs and that is all that you need to do.
Vanguard Total Stock Market (VTI) – This one provides you with all the stocks in the US – small,mid and large cap as well as all different sectors. And as about 40% of these companies’ income comes internationally you also get international exposure. If you do not feel like researching companies and trying to diversify yourself just buy this one ETF and you are good to go.
Vanguard Total Bond Market (BND)- The same principle, but for bonds. With this ETF you get exposure to all the bonds in the US. You don’t need to worry about diversification as it is already done for you.
I understand that the world of investing looks very complicated and foreign to people that have never been interested in it. If you are one of them you can just buy those 2 ETFs and carry on with your life. You don’t need any experience or knowledge to do that. You can buy them through any brokerage as they are traded just like any other stock.
Portfolio Guidance
Now as you already know portfolios can be either risky, moderate or conservative. In order to build a risky portfolio you want aggresive picks, for conservative you want defensive ones. Now let me explain what that means.
Defensive Picks
Those are stocks that are less volatile, have less risk and are not very correlated to market cycles. Defensive sectors are consumer staples, utilities, healthcare and communications. People need to eat, use a phone, gas, water, electricity and medical care no matter what. Also those stocks usually pay dividends, which helps to offset potential losses during a downturn.
By picking defensive stocks you protect yourself from potential big losses in your portfolio, but you also limit your growth potential. These kind of stocks do not provide spectacular returns and that is why they are recommended for more conservative investors.
In the defensive picks we can also place bonds as well as physical investments like real estate or land or gold. Physical investments are a good way to protect yourself against inflation. No matter how much the dollar is worth one house is still going to be one house.
Aggressive Picks
Here we have those high-potential growth stocks, which come with a bigger amount of risk as well. Aggressive stocks are most technology companies, most of the small-cap companies, biotech companies and others. They usually do not pay a dividend, because they reinvest the money back into the business to increase their growth.
In these stocks you can see a lot of volatility, a lot of risk and a lot of potential return. That is why those stocks are recommended for more risky investors and can be a good part of a risky portfolio.
In the aggressive picks we can add international stocks from less known markets with big potential as well real estate in more speculative markets.
Hedge Picks
First let’s explain what is a hedge. It is a way to protect your portfolio against different events. For example you can buy gold to protect against inflation. No matter how much the dollar is worth your ounce of gold is still going to be an ounce of gold. You can hedge against a possible recession with holding some cash. If the total value of your portfolio drops the cash still stays the same amount in your portfolio/account.
There are also more advanced ways to hedging your portfolio by using things like short positions and options, but I am not a fan of those and I do not use them myself. These options are mostly used by big hedge fund managers that have access to a lot of capital and very advanced technology that helps them. The regular retail investors like you and me are better off without them.
What I advice you to do is not go crazy on the hedging. For example it is not a bad idea to have a small part of your portfolio in gold to balance your risk. But I do not recommend having anything more than 5% of your portfolio there. After all the gold is not as asset and is just a way to reduce your risk. It does not produce anything and therefore you should not expect to make any returns by holding gold. It is just a way to protect yourself.
Rebalancing
Having a portfolio is very similar to having a garden. If you take good care of your garden you are going to bear the fruits of it. And that means that you have to water it and take out the weeds periodically.
In terms of your portfolio watering it means reinvesting your dividends and contributing regularly. Taking out the weeds means selling the stocks that have changed fundamentally and are no longer the same as once you initially invested in them. Everyone picks the wrong stock every now and again, but is important to know when you have made a mistake and to just let it go.
A lot of people make the mistake of averaging down in a company in a dying industry for example. This is like watering the weeds in your garden. If you keep watering them they are sooner or later going to destroy your it.
I advice you to check your portfolio quarterly and make a thorough portfolio review once a year. Take a look at how are your companies managing their debt, are there any changes in the management team, are they growing etc.
If you see too much worrying factors in one of your companies start a further investigation. If you see that the fundamentals are not the same as once you invested in them maybe it is a good idea to let it go.
In a perfect world the best thing is to never have to sell a company, but things change, industries change and teams change.
On the other hand if you see one of your companies down with no fundamental changes it is a good idea to buy more shares. After all everyone loves a good discount right?
Tax Protection
By saving on tax you are essentially boosting the returns on your portfolio. Luckily today there are a lot of things you can do to avoid being taxed on your investment. If you have a matched workplace pension make sure to use it.
If you are from the UK make sure to invest in a S&S ISA (Stocks and Shares Individual Savings Account). This way all your capital gains and UK dividends are going to be tax-free. Using a service like this is a no-brainer and is going to make a huge difference in the long-term.
As for people outside the UK there are similar options in a lot of other countries. In the US is a Roth-IRA, canadians have a FTSA and so on. Make sure you do your research and find the best possible brokerage account tax-wise. In the long-run this is going to make a very big difference in your portfolio.
Portfolio Examples
There are a couple different paths you can go in building your portfolio. You can start by either adding individual stocks, by adding ETFs or by a mixture of both. I will try to explain that by going through 3 different portfolios.
Warren Buffett’s Portfolio
Probably most of you know who Warren Buffett is – he is considered the most succesful investor of the 20th century with annual returns of over 20%. This is beyond impressive given his track record of over 50 years.
Let’s take a look at what has that compounding achieved for his networth over time.
Now let’s take a look at what his portfolio looks like at 2019.
Apple (AAPL) – 21.5%
Bank of America (BAC) – 12.06%
Wells Fargo (WFC) – 10.74%
Coca-Cola (KO) – 10.35%
American Express (AXP) – 7.89%
Kraft-Heinz (KHC) – 7.66%
U.S Bancorp (USB) – 3.23%
J.P. Morgan (JPM) – 2.68%
Bank of New York Mellon (BK) – 2.08%
Moody’s Corporation (MCO) – 1.89%
Delta Air Lines (DAL) – 1.79%
Goldman Sachs (GS) – 1.67%
Other – 18.46%
Now bear in mind that this is only his stocks portfolio. His company Berkshire Hathaway is a huge conglomerate and owns a lot of businesses outright. He also have a lot of cash on his books that are not calculated, in here we are analyzing his stocks portfolio.
So there are a couple of interesting things that we can see. Number one is that 50% of his holdings are concentrated in only 4 companies. He owns or have stakes in hundreds of businesses, but he is very concentrated in only a couple of them. Well why is that?
Because he likes to stick to what he understands and he puts a remarkable amount of time in researching a given company. Be sure that he has been watching any of these companies for years before he invests in them. If he decides that a given company is worth 20% of his portfolio he is comfortable enough doing this and he has calculated the risk and return very carefully.
The next very interesting thing you can probably see is how much of his stocks are in the financial industry. 8 of his top 12 positions are in this industry 45% of his portfolio is in this sector. Why is he doing this?
Because he likes to invest in what he knows and he has the most expertise in this sector. That is what has brought him the most returns over the years and he is not going to change his approach all of a sudden. As I said having a plan and following it is crucial for achieving good returns.
Warren Buffett has followed his plan for more than 60 years and he is now in the top 5 richest people in the world. There are two very good sayings from him that sum up his approach.
”Wide diversification is only required when investors do not understand what they are doing.” – Warren Buffett
”Risk comes from not knowing what you’re doing.” – Warren Buffett
Still he is by no means not diversified. First he owns about 50 stocks and he also owns hundreds of businesses outright. He has exposure to all the sectors there are in the economy in one way or another. What he is doing though is focusing the most on things he knows the best.
Another thing about his portfolio is that he’s got a lot of cash. His total stock portfolio is worth around $200bln while his cash position is a little more than $100bln. That means that his largest position as of right now is cash at around 35%. But why is that?
It is because he puts a very thorough research before he buys a company. He determines what the right price is for him to buy. If the current price meets his target he goes and buys it. If it doesn’t he waits until the price is right.
Usually in the later stages of a market cycle things start getting more expensive and therefore more companies are out of his buying range. His cash position is actually a very good measure to see where are we in a market cycle. The less cash he has the more opportunities there are in the market.
Ray Dalio’s Portfolio
For those of you that haven’t heard of him Ray Dalio is managing Bridgewater Associates – the biggest hedge fund in the world with over $150bln of assets under management. He has a net worth of over $20bln and has achieved around 12% of average annual returns. Now let’s check out what his portfolio looks like in 2019.
Vanguard Emerging Markets ETF (VWO) – 17.7%
SPDR S&P500 ETF (SPY) – 17.2%
iShares Emerging Markets ETF (IEMG) – 6.2%
iShares S&P500 Index ETF (IVV) – 5.1%
SPDR Gold Trust (GLD) – 4.3%
iShares MSCI Emerging Markets (EEM) – 3.1%
iShares IBoxx Invest Grade Corp Bonds (LQD) – 2.6%
iShares Barclays 20+ Yr Treasury Bond (TLT) – 2.2%
iShares MSCI South Korea Index Fund (EWY) – 1.8%
iShares iBoxx High Yid Corporate Bond (HYG) -1.8%
iShares J. P. Morgan USD Emerging Markets Bond ETF (EMB) – 1.7%
iShares Gold Trust (IAU) – 1.3%
Others – 35.2%
We can see that his approach is totally different to Buffett’s. As you can see he is very broadly diversified in any possible asset class. His portfolio consists of us stocks, international stocks, gold and bonds with over 450 holdings in his portfolio.
While Warren Buffett’s strength is in picking individual companies Dalio’s is in macroeconomics. That is why he prefers ETFs as it is easier to follow a whole country or region’s economy this way.
As he is running a hedge fund he uses a lot of different techniques to hedge his portfolio. As you can see he has a good amount of gold, bonds and international exposure. He is also using more advanced techiques like options and short positions. He can do that because he has a team of thousands of people using different screeners and algorithms.
The thing he is most well-knows is how well he is doing during recessions. Usually his fund underperforms in bull markets, but then he gets the upper hand in recessions. For example last year the S&P500 was down around 5%. Dalio’s portfolio on the other hand was up by 18%.
You should know that as he is running a hedge fund his number 1 priority is to conserve people’s money. That is why he is so diversified making sure that people are not going to see big fluctuations in the portfolio.
Speaking about portfolios, I post monthly updates of my portfolio, if you are interested you can always check it out.
Conclusion
So let’s sum up everything so far. In order to build a good portfolio you need to do a couple of things.
- Focus on Your Strengths
- Be Patient
- Diversify Smartly
- Choose Your Strategy
- Stick With Your Strategy
If you follow those things you have every chance to do well in the stock market. It doesn’t matter if you are a beginner or not. There are different strategies that can work for everyone no matter the experience and knowledge.
Hope you guys found some value in the article and can now build your own personalised portfolio.