For successful investors, good portfolio management centres around building a well-balanced portfolio.
Portfolio management is the process of choosing and monitoring the investment holdings for an individual or institution.
4 balancing acts for a successful portfolio
For successful investors, good portfolio management will include these 4 balancing acts:
- Investor balancing act #1: Your portfolio strategy should begin with a fundamental piece of advice that we underline frequently. Spread your money out across most if not all of the 5 main economic sectors (Finance, Utilities, Manufacturing, Resources, and the Consumer sector). The proportions should depend on your objectives and the risk you can accept. The Finance and Utilities sectors involve below-average risk. Manufacturing and Resources tend to be riskier, and the Consumer sector is in the middle.
- Investor balancing act #2: Balance aggressive and conservative investments in your portfolio, in line with your investment objectives, and the market outlook. Above all, avoid the urge to become more aggressive as prices rise and more conservative as prices fall.
- Investor balancing act #3: Good portfolio management also means balancing your investments geographically. Avoid focusing your portfolio on any one country or region. A lower-risk way to add international exposure to your portfolio is to hold multinational U.S. stocks, such as IBM, McDonald’s and Wal-Mart, which is now tapping into China. We cover all three of these companies in our Wall Street Stock Forecaster newsletter. What’s more, today’s lower U.S. dollar provides you with an opportunity to add high-quality U.S. stocks to your portfolio at bargain prices.
- Investor balancing act #4: Market leaders and market laggards both deserve a place in your portfolio. Over long periods, high-quality stocks play leapfrog. Some of the lowest-risk, highest-profit buys you’ll ever find are overlooked or out-of-fashion stocks of high investment quality that are coming back into investor favour.
How to cut risk and increase profits in your stock portfolio
Look beyond financial indicators: When they first set out to formulate an investment strategy, many investors decide to focus their stock market research on a handful of measures. For instance, they may want to see a p/e ratio (the ratio of a stock’s price to its per-share earnings) below 15.0, along with an earnings growth rate of 20% or more a year, and perhaps a 2% dividend yield.
If you find a stock with this (or any comparable) combination of favourable ratios, it probably comes with some more-or-less hidden drawback not covered by your system. Instead of steering you away from investments that you don’t understand, or that harbour hidden risk, this system will steer you toward them.
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Hold a reasonable portion of your portfolio in U.S. stocks: We continue to recommend that Canadian investors diversify part of their portfolio (up to 25%, say) in well-established U.S. stocks. That’s because the U.S. market features major multinational opportunities that simply aren’t available anywhere else. As well, many U.S. firms are unique world leaders.
Think like a portfolio manager: As part of their stock market research, portfolio managers gather information from companies, industry studies and other sources. A good portfolio manager then tries to build their client a portfolio that makes money if things go well, but won’t lose too much if the opinions turn out to be faulty, as often happens.
Give your investments time to pay off: Resist the ever-present urge to buy and sell. A sound portfolio, built through careful research, needs surprisingly few changes over the years. Trading less frequently is a good thing, because it gives you fewer occasions to make costly mistakes.
Diversify geographically: One of the worst things you can do is invest so that your portfolio would suffer a great deal due to a localized downturn in any one city, state or province. Ideally, your portfolio should give you exposure to much of the North American economy, plus substantial international exposure, if only through North American multinationals.
Develop a clear idea of how much risk you are willing to accept, through good times and bad: For example, some investors become more aggressive as the market rises, and more conservative as the market falls. The problem here is that all market trends, up or down, eventually reach a turning point. If you take on more risk as the market rises, you’ll wind up owning your riskiest portfolio just when the market is near a peak. That’s when risky stocks can do their greatest harm to your net worth.
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3 reasons why a sector rotation strategy won’t work
Instead of portfolio diversification approaches like ours, some investors practice “sector rotation.” That’s where you try to predict which sectors will outperform other sectors. But trying to pick winning sectors—and stay out of other sectors—seldom works over long periods. That’s because you need to guess right three times to succeed.
A sector rotation strategy may work in a given year when the economy behaves more or less predictably. However, it is difficult if not impossible to produce consistent longer-term returns with this strategy. Here are 3 reasons why:
- You need to guess right three times to profit from a sector rotation strategy: You have to pick the top sectors, then pick the stocks that will rise within those sectors, and then sell before the sector stumbles. It’s virtually impossible to consistently succeed at all three over long periods. But that’s not the only problem with this strategy.
- Sector rotation can push you into the worst-performing sectors: There are many theories about which sectors will outperform at any given stage of the economic cycle. But trying to pick winning sectors—and staying out of other sectors—seldom works over long periods. Investors who attempt to do so often wind up with heavy holdings in the worst-performing sectors. That would be devastating to your portfolio, even if you confine your investments to well-established companies.
- A sector rotation strategy costs money: Every time you move to a new sector you get charged fees twice. Once when you sell your holdings in the old sector and then again when you purchase holdings in the new sector. This may not be a big deal for investors who use discount brokers, but trading fees and commissions add up. These fees will eat into your profits.
5 easy investment tips for better long-term returns from personal wealth management
- Be skeptical. No matter how attractive they may seem, always take a skeptical approach to investment products that add an extra percentage point or more to your yearly costs. Make sure the expense is worth it.
- Understand compounding, It’s how your personal wealth grows. Compound interest is earning interest on interest. Over time, your long-term investments will earn more and more money from the effects of compound interest. Compound interest is what makes investing a worthwhile pursuit. Compound interest is applied to dividend-paying equity investments like stocks, as well as to fixed-return, interest-paying investments like bonds. When you earn a return on past investment returns (including dividends), the value of your investment can multiply. Instead of rising at a steady rate, the number of dollars in your portfolio will grow at an accelerating rate. It’s very important to keep an eye on investments or expense fees that affect the amount of interest you earn. Even 1% a year can be huge drain on your portfolio.
- Seek dividends in your investments. If you’re new to investing, one tip we share often is to invest in companies that have been paying a dividend for 5 or more years. Dividends are typically cash payouts that serve as a way for companies to share the wealth they’ve accumulated. These payouts are drawn from earnings and cash flow and paid to the shareholders of the company. Typically these dividends are paid quarterly, although they may be paid annually or even monthly as well. Canadian citizens who own shares in Canadian stocks that pay dividends will also benefit from a special tax break they may be eligible to receive.
- Don’t take advice that comes from advisors or institutions that sell insurance or other fee-heavy investment/financial products. The financial software they use just naturally spits out investment plans that involve the kind of sometimes-hidden costs in point 1.
- Only buy bonds or other fixed-return investments if interest rates are high enough to be attractive. Don’t buy bonds just to “cut your risk.” Adding bonds to the mix will simply cut the volatility of your portfolio value in any given year. But it does so at the cost of increasing your risk of loss to inflation.
4 risks of relying too heavily on p/e ratios
The p/e ratio (the ratio of a stock’s price to its per-share earnings) is one of many handy investing tools.
Typically, you calculate p/e’s using a stock’s current price and its earnings for the previous 12 months. The general rule is that the lower a stock’s p/e, the better. And a p/e of less than, say, 10, represents excellent value. A low p/e implies more profit for every dollar you invest.
There’s no doubt that p/e ratios are an important part of many investors’ decision making. These financial ratios are published regularly on the Internet and in newspapers, and are widely followed.
P/e financial ratios are a good starting point for researching a stock you’re considering buying (or selling). But relying too heavily on these financial ratios can expose you to serious risk. Here are 4 risks of relying too heavily on p/e ratios.
- P/e’s can give you a misleading picture of a company’s earnings
- Beware of suspiciously low p/e’s
- Don’t discount stocks with high p/e’s
- Low p/e ratios can mask hidden value
Follow our three-part Successful Investor strategy
- Invest mainly in well-established companies;
- Spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; the Consumer sector; Finance; Utilities);
- Downplay or avoid stocks in the broker/media limelight.
How active are you in the management of your investment portfolio? What strategies do you use to manage your investment portfolio? Share your experience with us in comments.