Many newcomers to share investing spend a couple of agonising months tossing up which stocks to buy, and after taking the plunge into their first share purchase begin snatching up stocks at an increasing rate. Stock picking is where the action is, and the consumer in us is compelled to buy up big and fast. But we easily forget that the real aim here is to construct a share portfolio. And whether we like it or not, random stock picking won't give you a well-constructed share portfolio.
There’s a more important reason, however, for why you must spend time constructing a solid and dependendable portfolio. Too many investors nurse war wounds of past sharemarket corrections that have trampled on their wealth and future lifestyle. Your portfolio, therefore, should be built to withstand the ebbs and flows of the market. Inevitably you will lose some money along the way, but like a little boat out at sea you don’t want to get capsized in rough conditions.
Financial planners harp on about diversification like scolding parents. "Don’t put all your eggs in one basket," is the adviser mantra. While the repetition is often enough to make us act in the opposite manner, what the advisers are stressing is undoubtedly the secret to not just making money but also staying in the game.
Diversification means not holding Westpac, National Australia Bank, Commonwealth Bank and ANZ in a portfolio, unless of course, your portfolio is so large that the financials bent doesn’t leave you too exposed. It also means not buying just resources stocks or speculative miners, too many cyclical stocks in industries that tend to move in sync, or defensive stocks during times of prosperity and growth. Diversification is the secret armour of the seasoned investor whose fortune is amassed during good and bad times.
The trouble with seeking diversification in a portfolio is that you need a lot of money to do it. If you have $5000 to spend, you simply don’t have enough to construct a diversified portfolio. So what should you do?
A handy fix to the diversification problem is to go out and purchase almost every stock in the Australian Stock Exchange (ASX); that way you’ll have exposure to large and small caps across every available industry – resources, industrials, healthcare, telecommunications, financials, utilities and so on. But how can this be a quick fix if you don’t have enough money? Well, you do.
There are instruments that purchase the stocks, package them up, and sell it to you. So rather than you having to go out and buy thousands of individual stocks, you simply buy a single instrument. Both exchange traded funds (ETFs) and index funds can be purchased in Australia that give instant exposure to the entire market. These instruments track indices such as the S&P/ASX 200 index, by proportionally holding all stocks in the index and mirroring its performance. The difference between ETFs and index funds is that ETFs are listed on the ASX, just like an ordinary share, and index funds are not.
Purchasing an instant diversifier – such as an ETF or index fund – is a handy option for investors just starting out. But once purchased that’s not the end of the diversification story.
With your ETF or index fund in hand, you must begin the process of picking stocks for your portfolio. But how many stocks should you hold at any given time?
Professional investors like to hold around 40 stocks in a portfolio, believing that this level of diversification minimises risk. If one stock falls over, well at least you have another 39 stocks that are still standing.
For most of us, however, babysitting 40 stocks can be a bit of a handful so many stockbrokers recommend holding around 10 to 15 stocks for their clients. This provides sufficient diversification without turning the maintenance of your share portfolio into a full-time job.
Just remember, however, that like adding water to concentrated cordial, the more stocks you add to a portfolio the more diluted the portfolio becomes. While your risk level falls, so do your likely returns. On the other hand, holding just one or two stocks is downright stupid so it’s a matter of getting a balance between holding too many stocks and not enough.