Building Your Stock Portfolio

Planning your stock portfolio allocation is the key factor for overall investment success. As was mentioned previously, the notion of constantly looking for new stocks to buy in order to get quick returns is a bit utopian and rather unrealistic. Building a stock portfolio takes strategy and commitment.

How do you build a stock portfolio?

Diversification is crucial. Putting all your money into one stock is a recipe for disaster. You need to mitigate as much risk as possible. How does diversification work? Imagine a scenario where you have $100 in cash ready for investing, and there are a bunch of stocks available for purchase. All stocks have a 95% chance of increasing your $100 to $116, and a 5% chance of losing everything. That means, at the end of the year, you will average ($116*0.95) + ($0*.05) = $110, or a 10% return on your money.

If you put all of your money into one stock, your expected return (or average) will be 10%, and your standard deviation or measure of risk (see 2 posts ago for explanation of standard deviation) will be equal to about 25.3%. For those interested, I used the formula:



Now, imagine that with your $100, you bought 20 different stocks, for $5 each. Your average return will still be 10% - in other words, at the end of the day, your $100 will still become $110 at the end of the year on average. However, if you do the standard deviation calculation, you will notice that your standard deviation in that case is only equal to about 5.5% (assuming a correlation of 0 between the 20 stocks – to be explained later).

How about that! Without sacrificing any returns, you managed to reduce your overall portfolio risk, simply by investing your money in 20 stocks instead of 1, even though all of the 20 stocks have exactly the same average return and standard deviation (individually) as each other!
Now you’re probably not as excited as I am about statistics. But the point is, diversification works.

However, there is one key caveat to diversification. Diversification only works if stocks move independently of one another. Back to our example of 20 stocks – if they all go up and down at the same time, in other words – they are perfectly correlated with each other, than the magic of diversification disappears. Why? Because if the correlation is perfect, you are essentially buying the same stock 20 times. This may be a bit hard for some of you to understand, but just trust me. In the example I used above, I assumed that all of the stocks move independently of one another. If one stock loses everything, that has no statistical bearing on the other 19 stocks. The other 19 stocks still have a 95% of growing by 16% and a 5% of losing everything. However, if when one stock falls, they all start falling, then the entire diversification strategy falls apart, and your overall standard deviation remains unchanged at 0.253.

One more mathematical concept to understand, and then you’re set to apply it to the real world. Correlation can be measured. A correlation of 1 is perfect correlation, or that when one stock goes up, the other stock will always go up as well, by the same proportion. A correlation of 0 means that there is zero correlation (like in the example used above). A correlation of -1 means negative correlation, or that when one stock goes up, the other stock always goes down by the same proportion. However, you are not just limited to 1, 0, or -1; you can have any value in between. A correlation of 0.5 means that when one stock goes up, the other stock also goes up, but by an average of only 50% as much.

Why am I telling you this? Because, let’s say, you want to invest your money in stocks, and you really like Apple stock (NASDAQ:AAPL). But then you remember Nechemya telling you that you shouldn’t put all your money in one stock. So you decide to put half your money in Apple and half in Microsoft (NASDAQ:MSFT). While that is certainly a better strategy than putting all your money into just Apple, because you have mitigated some of the risk by diversifying into 2 stocks rather than 1, it’s still a bit of a flawed idea. Why? Apple and Microsoft are both in the same industry (technology) and are therefore probably highly correlated with each other. If you put half of your money in Apple, and half of your money into Gillette, then you have achieved even greater diversification.

Companies within similar industries tend to have higher correlations with each other, as opposed to companies that are in different industries. This makes logical sense – take for example, Barrick gold and El Dorado gold. Both companies are involved in gold mining. If the price of gold decreases substantially, both Barrick and El Dorado will probably subsequently lose value. They often move together because they are affected by the same external environment. However, will Apple stock fall if the price of gold falls? Probably not. Therefore, by investing in Barrick and Apple (instead of Barrick and El Dorado), you are mitigating the risk of gold prices falling and negatively affecting your portfolio.

This same concept works for local vs. international companies. If you put all your money in Canadian stocks, then any factor that affects the Canadian economy is a risk factor for your portfolio. For example, if the Canadian government raises interest rates, a lot of the Canadian stocks you own may fall. So why not also buy American stocks. Throw in international stocks as well. In fact, the more you diversify the more risk you are mitigating. So, always diversify, preferably into stocks that are not strongly correlated with each other.

In fact, this same concept works for allocation classes. Why put all your money in stocks, when the stock markets are correlated with each other? That is why the best portfolios contain all allocation classes. For example, as I posted about 3 weeks ago, a properly diversified overall portfolio may resemble this:

65% stocks
15% bonds
5% precious metals/commodities
5% real estate
10% cash and cash equivalents

How many stocks do you need in order to maintain good diversification? An educated financial planner can probably effectively diversify with about 30 stocks. However, buying 30 stocks is extremely expensive, because there are transaction costs for each purchase you make. As well, it can be very time-consuming to research 30 stocks, and the mathematics of diversification can get pretty complicated.

There is an alternative. We have previously talked so much about mutual funds – this is exactly the reason why mutual funds are so popular. Mutual funds invest in hundreds, if not thousands of different stocks; all the while, you only need to make one payment to the fund. A mutual fund is a collection of money pooled together by many investors, and managed by a professional money manager. Therefore, with one purchase, you can own thousands of stocks at once, and achieve high levels of diversification.

The problem is that most mutual funds don’t do very well, and charge way too much money compared to the returns they give (see last week’s post). However, there are alternatives. Exchange traded funds (ETFs) are a wonderful alternative to mutual funds. I’d recommend researching on the internet about how an ETF works, or asking your financial planner. If you are the type of investor that wants a safe, easy way to invest in stocks without having to constantly monitor your portfolio, consider purchasing an ETF that invests in market indices all over the world.

Please remember to speak to a financial advisor before making large purchases in the stock market. Next week I will be discussing RRSPs and TFSAs.

Lastly, although younger investors are often fascinated by the stock market and the supposed riches they promise, do you remember what I said was the best way to save money and increase your wealth (about 5 weeks ago)?

Spend less than you earn.