How to Build a Stock Portfolio

The key to building wealth is not by seeking big gains in your portfolio; instead, it is by minimizing your losses during market declines. The best way to accomplish that is through diversification. Diversification is the acknowledgment that it is nearly impossible to know which asset class or market sector will outperform another and that different sectors or asset classes perform differently. So, instead of trying to guess, diversification enables you to capture market returns wherever and whenever they might occur while keeping the overall volatility of your portfolio low. When correctly done, a diversified portfolio should outperform a more concentrated portfolio over the long term.

How Many Stocks to Diversify?

Your portfolio should be diversified to the extent that it gives you exposure to a broad cross-section of the market, but not so much that you dilute your ability to research stocks and monitor them after buying them. One rule of thumb is to own a minimum of three to five stocks in at least four or five industries. This can give you reasonably broad exposure without being so cumbersome that you can’t stay on top of the companies you own.

Research has shown that, over time, value stocks – undervalued stocks with slower earnings growth than growth stocks – outperform growth stocks, and small-cap stocks outperform large-cap stocks. However, because it’s nearly impossible to know which types of stocks will outperform at any given time, it’s essential to own a combination of growth, value, large-cap, and small-cap stocks.

Exercise Patience and Discipline

As Warren Buffett once quipped, “The stock market is a highly efficient mechanism for the transfer of wealth from the impatient to the patient. Studies have shown that the more often investors monitor or tweak their portfolio, the worse it performs. That tends to happen when investors become distracted by the short-term performance of their stocks, and the results are almost always negative.

Having the discipline to stay the course amid extreme market fluctuations doesn’t come naturally to most people. However, for those who keep their focus on their investment objectives and stay the course, they are less likely to react in sympathy with the panicking herd. Disciplined investors understand the nature of volatility and why it’s essential in achieving positive, long-term returns. They also know that the longer they maintain their stock positions, they will experience negative returns along with extended periods of positive returns.

How to Avoid Mistakes When Picking a Stock

Don’t base stock selection on price alone. Just because a stock drops in value doesn’t mean it’s a bargain. Find out the reason behind the price drop and how strong the opportunity is for a rebound.

Take analysts’ recommendations with a grain of salt. While stock analysts can be a source of good information, it’s important to understand that it could be tainted with bias, especially when they issue a buy recommendation.

Avoid purchasing “headline” stocks. Stocks such as Facebook, Netflix, and Amazon drive a lot of the trading activity in the market each day. Buying these “headline” stocks just because they are hot is like trying to jump on a moving bus – you’re more likely to faceplant than get to your destination.

Don’t be consumed with volatility. There’s always going to be more volatility with individual stocks than a diversified mutual fund. Your research should have told you what the 52-week trading range of your stock is. They are likely to repeat that range.

Don’t forget to set targets for your stocks. Just as you have a process for buying stocks, you need a process for telling you when it’s time to sell. You should set a target objective for the upside as well as a target for the downside. You should set some criteria for guiding your decision to sell, such as if the company’s earnings fall in consecutive quarters, or it cuts its dividend, or if there is a significant change in management.

Conclusion

It is well-established that stocks have been the best performing asset for building wealth over the last century. With a universe of more than 100,000 stock issues, it may seem as if choosing the right stocks is like finding a needle in a haystack and choosing the wrong stocks can be detrimental to your wealth. However, with the right knowledge, patience and discipline, and a process for finding, analyzing, and selecting stocks, anyone can learn how to choose the right stock.