How to build an equity portfolio?
There are literally thousands of businesses. In the United Kingdom, Europe, the world... the choice is vast and almost unlimited. When you want to build an equity portfolio, the immediate question is: what stocks will I add to my portfolio?
Hold on! No rush! Don't tell me you intend to buy stocks before strategizing?
Having a strategy
The most important rule here is that before doing anything on the markets, you need to have a global strategy and a specific objective. Investing in the stock market is no trivial matter. The choice is so great that you need a clear idea of what you want to accomplish.
There are also many strategies. Everyone has their tastes, their affinities, their knowledge, their experiences, etc. The purpose and the “why” of the investment are therefore specific to each.
Once the overall strategy has been established, you need to consider how to select stocks, but this will be done in a second step.
Here are some examples of strategies - there are of course others.
Dividends: a commonly used strategy is that of dividends. The investor builds up a portfolio of companies that pay higher or lower dividends. They are generally fairly stable or grow over time. Each quarter or year, depending on the market and the company, the investor receives dividends that are proportionate to their investments. Dividends are therefore a kind of remuneration that is more or less predictable.
Growth: this strategy aims to buy stocks that have great potential for growth. Dividends don’t matter much, but we hope that the stock market will go up in the months or years to come. Small or medium-sized businesses are typically in this category, as are companies in the Internet / High Tech sector.
Value: here we are interested in companies that are generally undervalued, i.e. that the share price does not reflect the intrinsic value of the company. In a way, these are "affordable" or "cheap" companies. Please note, selecting “valuable” stocks is a fine art. On the other hand, what is expensive or not is a relative concept.
Sector: the idea is to only position yourself on specific sectors for which we have a medium or long-term vision, e.g. the health sector.
These are fairly classic and popular strategies. However, you can have fun using several to establish a more targeted strategy, for example positioning yourself on large companies in the health sector that pay dividends.
Once you have established a strategy, it is time to select the stocks to add to your portfolio. We generally proceed in a funnel, with a series of criteria which will ultimately limit the investable scope and the amount of available stocks.
Using our previous example, the criteria would be: large market capitalizations (over $10 billion), health sector, yield above 3%. We could add a geographic area, such as Europe or the UK.
For this preliminary exercise, “stock screeners” are very useful. They make it possible to adjust a large number of technical and financial criteria.
After that, few companies can meet all the criteria. Sometimes it will even be necessary to relax certain criteria in order to have a wider choice.
At this stage it will therefore be important to analyse the companies one by one and go from the bottom-up, i.e. make a fundamental study of individual companies and see whether an investment fits your overall strategy.
Diversification and risk
Another question quickly arises when you want to build an equity portfolio: how many stocks should I have in total and in which proportion (weight of each stock in the portfolio)?
Some large American investors such as Warren Buffet focus their investments on a dozen companies. For example, 3 or 4 companies take up 80% of their portfolio and the remaining 20% is divided among twenty other stocks.
What is the right solution?
First, it will depend on your initial strategy, your beliefs in the market, macroeconomics and the stocks you have selected.
Then, a core principle in the investment world is diversification, in order to reduce risk for instance. But we also know that too much diversification reduces potential performance too. This is what the stock market game is all about: optimizing the risk/return balance, i.e. maximizing performance while controlling risks...
So, what to do? Unfortunately (or fortunately) there are no miracle solutions, and everyone will have to conduct their own analysis and have their own ideas to build a portfolio that suits them and with which they are comfortable. Because this is undoubtedly the key: investing is a long-term process. We need to be in perfect agreement with the decisions taken and be able to sustain them for a certain time, or on the contrary not hesitate to resell when the possession of a stock makes us sick.
Last Update on 26/06/20