4 important rules of the forming a stock portfolio

Not every portfolio will bring real benefit to its owner if it was composed with mistakes. We prepared several useful rules for you, which will help to make investing more efficient.

Rule 1. Buy only those companies which you understand

“Investing without research is like playing stud poker and never looking at the cards” – this is what a legendary investor Peter Lynch thinks. He is sure that if you cannot explain the stock purchase idea to a fifth-grade secondary school student, your investment is destined for failure.

A thorough study of stocks is the foundation of the portfolio approach. You need to identify prospects of the company business development, how fair its value is compared to competitors, whether it conducts a reasonable borrowing policy and whether it pays dividends.

When investors form a list, they are mainly based on fundamental analysis. The most popular methods are based on Benjamin Graham books The Intelligent Investor and Security Analysis. An investor Warren Buffett, whose personal capital reached USD 100 billion in 2021, applied them most successfully.

It is also useful to read the Beating the Street book by the above mentioned Lynch, where he explains methods of selecting high-grade companies, which he developed for decades of being in the investment business, in a simple and clear language.

Rule 2. Portfolio should be diversified

You can buy a big set of stocks but it will not be a portfolio. The main task of portfolio investment is to reduce risks of individual stocks and industries by means of diversification.

Diversification means that your portfolio is split between various companies from various industries. However, a portfolio should not be just split, it should take into account correlation. The less a correlation between individual stocks, the lower your risks and higher the chances to make money. This is what the founder of one of the most successful hedge funds of the world Ray Dalio says. There are several useful videos on the Internet, in which Ray Dalio explains everything in simple terms.

Let’s take a simple example. Financial companies and banks feel themselves awful in crisis times, while pharmaceutical businesses and producers of cheap food products keep afloat quite well. When the economic cycle reverses and the bets start to grow, the banks boom while pharmacologists can show only slow rates of development.

Nobody will tell you for sure how many stocks should be in your portfolio for good diversification. The general rule says that a beginner should select 10-20 very good and easy-to-understand companies rather than 40-50 of all in sight.

Rule 3. Not only stocks should be included in an investment portfolio

However good you are in selecting stocks, correlation between them should stay rather high. It happens quite often in the US stock market when up to 90% of all stocks are in a downtrend or uptrend simultaneously. In view of this, it makes sense to study capacities of other instruments, such as options, gold and bonds.

Rule 4. Take into account cash flows

You can have great ideas, but the stock market rules are dictated by the central bank policy and liquidity flows in the world. While huge volumes of money are printed in the world and interest rates are at the zero level, more risky positions in a portfolio could be justified. In the event of the plans to raise interest rates, the priority may switch to the real economy companies and banks with stable dividends and stable business models.

Of course, not every person is ready to go deep into financial analytics. Also, not every beginner has sufficient capital for composing a sound portfolio. But what to do if you still want to have a stock portfolio? Various ETF, which allow a significant simplification of the process and reduction of expenditures, will help you to do it.

Warren Buffet also recommends unprofessional investors not to enter into details and invest in ETF. Not even all professional investors in the world manage to consistently outplay the wide S&P 500 stock index. There are a lot of cheap ETF in the US stock market.

The main ETF advantages for a beginner are the following:

1. ETF significantly simplify the possibility to invest in indices. You can do it just clicking your mouse button several times.
2. You can buy an ETF as easy as a regular stock. Nearly all major brokers provide access to it.
3. There is a huge variety of industry-specific ETF. There are funds that invest in highly profitable start-ups, indices, raw material companies, precious metals, banks, bonds, etc.
4. ETF provide a possibility to invest in leading dividend stocks.
5. The market entry threshold goes down from USD 15-20 thousand to USD 2-5 thousand.
6. Professional managers deal with ETF rebalancing.
7. A nominal fee for management – usually 0.1%-1%.

As you can see, there are many advantages and they are rather strong. This allows calling an ETF a real present for beginners and the best alternative to an individual portfolio composition.