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A Simple Formula for a Successful PortfolioBy
Thursday, January 16, 2014
It's the simplest way to get started in the markets...
As I explained yesterday, if you are just getting started investing and want to deploy a large amount of capital that you're counting on for the future... mutual funds are ideal.
But if you're talking about starting with, say, a $5,000-$10,000 bonus from work or an inheritance, you may want to try building your own mutual-fund-like portfolio.
Today's essay can help you with that...
First, remember two of the most important, fundamental concepts for investing success: diversification and compounding returns.
No matter how experienced you are as an investor, it's important to always think about these two ideas when committing your capital. And for beginning investors, the sooner you understand these concepts, the sooner you are on the road to building your wealth.
I've discussed these before. You can read more about compounding here and asset allocations here.
Compound returns are money you make off the money you make. Let's say you find a stock you like that pays a safe, rich 5% yield. You buy 100 shares for $10 each, for a total position value of $1,000. For simplicity, we'll assume the share price and the dividend stay fixed for a long time at $10 and 5%, respectively.
At the end of the first year, you'll receive $50 in dividends (5%). You take that payment and buy five more shares... This increases your position value to $1,050. In Year 2, you earn $52.50 in dividends. You reinvest this, too. Repeat this process for 12 years. In the 12th year, your position is worth $1,795.86, and you'll make $85.52 in dividends. That's an 8.55% dividend yield off your initial $1,000 investment.
Diversifying your portfolio is the key to avoiding catastrophic losses.
For instance, in my Retirement Millionaire portfolio, we've allocated a certain percentage of our funds to different assets – a mix of stocks, fixed income, chaos hedges, and cash. So even when one asset isn't doing so well (say for example, stocks in 2008), we're protected.
If you're building your own portfolio... it's also important to diversify your stock holdings across several different business sectors. Sectors post dramatically different returns from year to year (though research shows the differences even out over time).
For 2013, the stock market returned 29%, but there was a large spread. The consumer discretionary sector returned 41%. Telecom services returned only 6.5%.
You need to pick multiple stocks and multiple sectors... stocks that will provide returns independent of each other. For instance, pick an energy stock, a technology stock, and a company that produces consumer staples. These companies will be influenced by different factors, unrelated to each other.
Rising oil prices will drive energy stocks up, while pushing industrial stocks down (because of rising fuel costs). An improving economy will benefit consumer discretionary stocks, while leaving consumer staples behind.
Of course, they may all move together if stocks are in a bull market or bear market. That's why holding a variety of asset classes – like bonds – is important.
With one stock, you can win big. But you have high risk. You could lose it all. But as you own more and more stocks, your risk goes down. At the same time, the more you own, the more likely you are to earn the "market return." For stocks, that has been about 7% or 8% a year over the past 50-100 years, depending on which study you look at.
Deciding which sector to invest in at any one time – and identifying the best stocks in those sectors – is a key part of our strategy in my Retirement Millionaire newsletter.
So for example, a simple, low-risk starter portfolio might include three to five stocks from sectors such as consumer spending (companies like Wal-Mart), energy, and financial services. It might also include one or two fixed-income positions (like in one of my favorite investments, municipal bonds). You'd also want to keep some of your portfolio in cash and what we call "chaos hedges." (To learn more about how we structure a portfolio and my favorite current recommendations, you can sign up for a subscription to Retirement Millionaire here.)
It doesn't take a lot of experience or money to start investing. You can start with as little as $25 a month to work your way to financial independence. Mutual funds make it easy to diversify and allocate your portfolio to make the most of your money, while keeping it safe.
But if you've got a little bit more money and an interest in learning how to pick your own investments, you can create your own diversified portfolio using the ideas above.
The most important thing to do is just to get started.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig
Further Reading:
Find more investing tips from Doc right here:
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Back in September 2011, we urged readers to consider buying airline stocks. Most folks thought we'd lost our minds. After all, airlines sport thin profit margins, suffer big swings in fuel costs, and require lots of ongoing investment just to keep business running. This makes them horrible long-term investments. But for traders, it's important to know that airlines go through big "boom and bust" cycles... which can be traded for big profits.
In our 2011 write-up, we noted that airlines had just experienced a bust. Many airline names, like giant Delta Air Lines (DAL), had lost over 40% of their value in just a few months. Sentiment toward the sector was terrible. This offered the chance to trade a "bad to less bad" rally...
As you can see from the updated Delta chart below, our expected rally arrived... and it was huge. Our chart displays the past three years of trading in Delta. Near the time we wrote our bullish note, Delta shares traded for around $8. They have rallied nearly 300% to reach a new high of $31.50 per share. "Bad to less bad" trading works!
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