"Anyone can pick a stock, but only a few can create a portfolio." -- A Wise Old Broker   AVE YOU REALLY LOOKED at your portfolio lately? Not just the performance, but the actual holdings? Do you know why you own those specific stocks (or bonds) or how they trade relative to one another? What would it take for you to sell or add to a position? Is this really a portfolio or just a collection of stocks? These are all issues of portfolio management -- the actual implementation of a strategy. In essence, you should have a clear idea of what you want your portfolio to look like. This includes the number of stocks, the types of companies and sectors represented, the size of your various positions, and how much cash (if any) to maintain. It's also a good idea to have a benchmark for your portfolio. Without one, it's difficult if not impossible to gauge how your investments are actually doing. Not only should you have one, you should have an appropriate one. If you've got a portfolio of small stocks, the S&P 500, a measure of large stocks isn't for you. That's also true if you have a mix of stocks and bonds. Many make this mistake (including Morningstar, the popular fund rating service) but you shouldn't. Diversification So where to begin? Start by thinking diversification. Sure, you've heard it a bazillion times -- diversification reduces risk. You might not think that's so important if you own quality companies, but you'd be wrong. Just consider the recent bear market. According to data from Ibbotson Associates, from September 2000 to September 2002, the Dow Jones Industrials -- that bastion of "safe" Now, if you have 6 - 10 mutual funds, do you think they all hold different stocks? It's more likely they all hold roughly the same thing… blue chip companies -- declined by a cumulative 29.8%. For those 25 months, it averaged an annualized loss of 14.3% per year. So much for safety in quality. Not only that, bad things happen to good companies. Remember the effect of the Tylenol tampering scare? How about the way Intel got hammered in 1994 when there was an incredibly insignificant flaw in the first Pentium processors? Hudson Foods never recovered from a relatively minor E. coli recall. Some ambulance-chaser sues Altria (née Philip Morris) just about everyday. The only way to protect your portfolio from these unexpected developments is to diversify. This doesn't just mean holding a number of different stocks, it also requires a number of stocks in different industries and sectors. If all you own NO SAFETY IN SIZE Source: Ibbotson Associates There was no safety in size in the 2000 - 2002 bear market. "Safe" blue-chips, as measured by the Dow Jones Industrials Average, and the "risky" small cap stocks of the Russell 2000 had roughly the same 30% loss over the period. is Ford and GM, you're still going to get killed if interest rates rise, the economy slows, and people stop buying (or leasing) cars. If you keep the Ford but swap the GM for International Paper, you've at least diversified across two industries. Nevertheless, both are still cyclical and economically sensitive, so your portfolio is still exposed in a slowing economy. A few defensive stocks -- those with steady earnings even in declining economies -- are needed to balance the mix. Yes, defensive issues don't do as well when the economy is booming, but they certainly provide a cushion when it erodes. Over the long-term, you'll be rewarded by better performance. Now you may have heard that the small investor shouldn't dabble in individual equities because he or she can't possibly afford proper diversification. You may have also heard that you need 6 - 10 mutual funds for this purpose. Odds are you heard both from a broker pushing funds. Diversification is a requirement in order to be listed as a mutual fund. Equity funds hold 50, 100, or even more issues. Some (remember Jeff Vinik's brief stint with Fidelity's Magellan Fund?) even hold bonds. Now, if you have 6 - 10 mutual funds, do you think they all hold different stocks? It's more likely they all hold roughly the same thing, regardless of their purported investment style. During the bull market of the 1990s, many turned into closet index funds. With the largest of the large caps outperforming the rest of the market, fund managers simply accumulated them while minimizing exposure to other sectors. Do you really need to duplicate this 6 - 10 times? When the bubble burst in 2000, those managers who outperformed tended to be those who held large cash positions, not winning equities. If you wanted to hold cash, you could do it yourself in a money market fund, rather than paying a "managed" mutual fund's fees of 1-2% a year. But how many stocks do you need for proper diversification? Probably less than you think. Studies conducted in the early 90's showed that there is little additional benefit once you surpass 10 - 15 diversified holdings. Your broker didn't tell you that, but then again, only trades generate commissions. STRUCTURING… Purchase 10-20 different stocks Hold stocks in different market sectors Purchase equal dollar amounts rather than equal share amounts Look for stocks in different industries. If you're using the minimum number, you probably don't want more than one representative in each industry. The more stocks you accumulate, the more diversification you can achieve within each industry. Also consider buying stocks of different size companies. In the 1990s, large caps led the way and eventually became extremely overpriced. Small stocks fared no worse in the bear market and outperformed in 2003's recovery. At that point large caps again offered better value. By holding (or moving between) both, you can improve long-term performance. Weighting... Once you know what you want to buy, you've got to decide how much to buy. Many investors buy in "round lots" -- numbers of shares evenly divisible by 100. There used to be a commission benefit to this, but not anymore. Instead of balancing your purchases by the number of shares, you're better off equalizing dollar amounts. Why? Well, suppose you have $100,000 to invest. Also suppose you want to buy 100 shares of both stock A and stock B. If stock A is $100/share and stock B is $40/share, you'll spend $10,000 and $4,000, EQUAL SHARES vs. EQUAL INVESTMENT If Stock A costs $100/share and Stock B costs $40/share, a 10% gain in both won't have the same effect if the portfolio contains an equal number of shares of each (top illustration). If instead, an equal dollar amount of each is purchased (bottom illustration), the portfolio will have two and a half times as many shares of Stock B, but equal percentage moves in both will yield the same results. respectively. Stock A will then be 10% of your portfolio, and stock B will be 4%. A 10% increase in stock A will add 1% to your portfolio, but an equal move in Stock B will only add .4%. See the problem? Same increase, vastly different impact. Both performed equally, but in dollars and cents -- what you really take to the bank -- stock A looks disproportionately better. Stock B would have to go up 25% to have the same impact on the portfolio. The same is true on the negative side, too. If stock A goes down 10% and stock B goes up 10%, they don't net out. Instead, (assuming the rest of the portfolio remains unchanged), you'd be down $6000, a 6% loss. For this to work the way you'd intuitively expect, the holdings need to be equally weighted. Instead of buying an equal number of shares, you'd invest equal amounts in each stock. In this example, if you buy 100 shares of stock A, you'd buy 250 shares of stock B. You'd have roughly $10,000 invested in each. If stock A went down 10% (-$10,000), and stock B went up 10% (+$10,000) the two would net out. With a weighted portfolio, identical percentage performance translates into identical dollar performance. There's nothing magical about this, it just makes sense. ..And Reweighting Obviously your stocks won't move in tandem. Even if you initially invest the same amount in each of your holdings, they won't perform identically. When that happens, they're no longer equally weighted. At that point, it's time to rebalance the portfolio. To do this, you simply apply your buy and sell strategy. Are the stocks with the greatest appreciation still buys or holds, or have they become sells? Perhaps you should sell all or part of the position. What about the laggards? Are they still worth holding? Have their fundamentals deteriorated from the time of purchase? If they're still buys, you can add to the position to bring up their weighting. If you've cooled to their prospects, you can solve the weighting problem by giving them the boot. < …and MAINTAINING Periodically rebalance Don't be afraid to sell losers -- bad can get worse Don't fall in love with your winners -- when you're at the top, there's only one way left to go Regardless of market fluctuations, don't abandon your buy and sell discipline The nice thing about this approach is that it encourages you to stick with your buy and sell strategy. If forces you to take profits from your winners rather than ride them all the way to the top and back down again. It also causes you to rethink your losers and possibly add to them when good stocks are down. But don't get overzealous with this rebalancing act. Stock prices change every day. As soon as you buy two stocks, their prices will change -- and not equally. If you had unlimited funds for trading commissions and an extremely patient broker, you could adjust your portfolio each day. But that would be goofy. It's better to set a limit (5%, 10%, or something equally arbitrary) at which you will consider rebalancing. Even then, if you feel each stock is still worth holding onto, you aren't obligated to do anything. Just live with it. Brokers are the only ones who benefit from trading for the sake of trading. No Obligations Keep in mind that you actually benefit by keeping transactions to a minimum. Each purchase or sale incurs a commission and possibly a tax liability. These expenses reduce your actual total return so a buy-and-hold strategy is both cost and tax efficient. Contrary to what you might hear, buy-and-hold is still a viable approach. If you're fully invested in stocks that meet all your requirements and you come up with another excellent candidate, then it's just too bad. As a wise old broker once said, "You can't dance with every girl at the ball." On the other hand, avoid being married to your stocks. Some folks will continue to hold a loser because they like "the concept" or think the As odd as it might seem, these "conservative investors" are market timers. rest of the world will eventually come around to their way of thinking. Don't fall into this trap! Your sell strategy should be fair and objective. If it says it's time to sell, it's time to sell. When you do buy a dog (everyone does occasionally), whatever you do, don't try to get even and get out. The stock price may eventually come back to where you bought it, but what have you given up by waiting? When you come to believe a stock is no longer worth owning, you're better off dumping it then and replacing it with a better prospect rather than trying to get even and get out. Who knows, you may even need to use this loss to offset all the other gains you'll have from the rest of your portfolio. Time In vs. Timing Some investors suffer from the opposite malady. As soon as one of their holdings goes up, they want to sell, fearing it'll go back down just as quickly. Brokers love these folks because they generate lots of When inflation's running rampant, what used to be a nickel cigar may cost a dollar, but it still tastes like a nickel cigar. trades. These Nervous Nellies may think they come out ahead, but between trading commissions, taxes on short-term gains, and missed opportunities, they leave a lot on the table. As odd as it might seem, these "conservative investors" are market timers. Although they may not be trying to buy at the bottom, they are attempting to jump out at the top, before their gains evaporate. It's virtually impossible to time the market. This is true whether you're an aggressive price momentum investor or a reticent Nervous Nellie. In fact, over the long-term, it's pointless to try to time the market. Statistics show that as participation has grown in the financial markets, volatility has increased. As a result, major gains (and losses) occur in only a small number of days during the year. If you're out of the market for just a few of them, you miss the major market moves. The market's long-term bias has always been up, so while being out of the market for those few down days may help in the short-term, missing the up days will have a much greater negative impact. Don't worry about market timing. It's Not All Relative Finally, there's no obligation to always be fully invested. In a rising and overvalued market, you may not be able to find any fairly valued stocks. When that happens, don't be tempted to buy whatever looks cheap relative to the market. When inflation's running rampant, what used to be a nickel cigar may cost a dollar, but it still tastes like a nickel cigar. Relative value is meaningless, it's simply a version of the "greater fool theory". If you can't find any stocks that you believe to be worth buying on their own merits, don't buy anything. There are plenty of stocks out there and you can't have considered them all. Keep looking. In the meantime, you're better off holding cash than buying overpriced equities. While your cash won't produce double digit returns, it won't crash and burn, either. Long-term gains aren't made through short-term trading. Structure your portfolio, maintain it, and stick with it.   E-mail your comments. Search this site! 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