Welcome to part 3! We’re going to get into the good stuff during this part, and actually begin to develop a portfolio strategy.
Regardless of your risk tolerance, which you would have figured out in part 2, the main goal of an investment strategy should be to maximize your returns while minimizing your risk. To do this, you need a well diversified portfolio.
So what exactly is portfolio diversification?
Simply put, diversification is the process through which one can balance out price movements among different securities. Even if you are considered an aggressive investor, your portfolio must be well diversified with aggressive investments. The definition of an aggressive investor is often misinterpreted, especially by those who crown themselves with the term. Investing 100% of your portfolio into 2 or 3 stocks isn’t aggressive investing, it’s investment suicide. And trust me, I’ve seen plenty of it.
There is no magic number when it comes to the amount of stocks you should hold in your portfolio. But, in my personal opinion, there is a lower and upper threshold that you should try and follow.
In terms of lower thresholds, the number really depends on the amount you have to invest. It doesn’t make sense for a person with $2000 to invest in 20 different stocks. For one, at even the cheapest commissions rates available of $5 dollars a trade, you’re eating up 5% of your investment portfolio in commission costs. However, you also shouldn’t be investing in only a couple stocks because you think you don’t have enough money to broaden your exposure.
In terms of upper thresholds, I believe that this too comes down to how much you have to invest in terms of both time and money. It’s important that you’re not over diversifying or spreading yourself too thin. The more stocks you own, the more research and ultimately time it takes to monitor your stocks. While a new retiree with a 6 figure portfolio may have several hours in a day to keep up with a portfolio of 25-40 stocks, to someone working a 9-5 job, this would become overwhelming and they will either end up ignoring them, or simply making mistakes.
My comfortable threshold right now is 15 stocks, unless I see an opportunity I cannot pass up. I mainly invest in growth stocks, this means the time needed for each company is substantially higher compared to blue-chip dividend stocks. When I was a dividend investor, my portfolio contained over 21 companies.
Lets talk about asset allocation
You’ve come up with the amount of stocks you’ll be able to manage comfortably, but you’re not diversified yet. We haven’t even made a purchase! The key now is to figure out how much of your portfolio you want to allocate to specific securities.
Stocks are only one portion of an investment portfolio. There are many other investment vehicles out there that you should consider adding to your portfolio. In Canada, these could be anything from bonds, GICs, or even cash.
My portfolio contains about 95% stocks and 5% cash. Most investors wouldn’t even come close to this. But, hear me out.
I hold almost a 100% stock based portfolio mostly due to the fact I am able to handle a more aggressive style of investing. I am young, nowhere near retirement and market fluctuations wouldn’t necessarily be detrimental to me at this stage of my life. But my ability to manage this large of an equity based portfolio comes down to two things. One I just explained above. Secondly, and this is probably the most important asset, is experience.
With this much allocation towards stocks, you’re going to see wild fluctuations. There was actually a period in late 2018 when the market took a nose dive and I lost 33% of my TFSA value in two weeks. The difference between me and an inexperienced investor is I didn’t sell anything. The less experienced you are, the smaller amount of high risk investments, like common stocks, you want in your portfolio.
If you’re just starting out, holding a 100% equity based portfolio would probably be a disaster, unless you get in the markets at the right time. Inexperienced investors often make sporadic decisions, such as selling off investments during market turmoil. If you’re a beginner, it would probably be wise to allocate less of your portfolio towards stocks, and more of your portfolio towards short term, low risk investments like GICs or bonds. After you gain the experience you need, you can begin to move more of these low risk investments into stocks, after they mature.
The biggest mistake I see new investors make is to simply place the money in a savings account while they learn. You probably know now from our previous parts that depending on your interest rate, the value of your money can actually be going down in a savings account. Get it invested, and get it working for you.
There is no one size fits all in terms of asset allocation
Experience aside, allocating your assets is completely up to the investor, but a decision is made using a combination of all the topics we have gone over so far. Age, risk tolerance, and investment goals.
There is something that still exists to this day called the “100 year rule.” The rule stated that you take your age and subtract it from 100 and you get the percentage allocation you should have in stocks. So, a 30 year old should have 100-30, or 70% of their portfolio in stocks. I don’t believe in this rule, at all, because it ignores the 3 fundamental things I stated above. Age, risk tolerance, and investment goals. However, it does have some relevance, as the older you get, the lower your allocation towards stocks should be.
An investor that is 60 years old and approaching retirement would be wise to have the majority of their investment holdings in low risk investments such as bonds, and a small portion in common stocks. Why?
Well, take my 100% stock based portfolio for example. For me, if the market were to crash, I am nowhere near retirement and have no need for that money any time soon. With my experience, I will be able to manage my holdings accordingly and tough out the current market conditions. For the 60 year who plans to retire in 5 years, a market crash of any significance could cripple their investment portfolio and actually force them to work years longer.
All in all, after taking the risk tolerance quiz in the previous part and deciding on your investment goals and return needed, developing a plan for your total asset allocation will not be hard. Once you’ve got that figured out, we can finally move on to part four, which talks about actually purchasing the stocks for your portfolio.