Most people buy stocks to earn returns that are higher than what they
would earn on fixed income or cash investments. However, owning stocks
involves risk. Your company's stock may fail to perform well or the overall
market declines and takes your stocks down with it. To reduce these risks and
to try to maximize the returns on your stock investments, it makes sense to
carefully build a portfolio of stocks.
There are no guarantees with stock investing, but here are four issues to
keep in mind:
-- What portion of your assets should be in stocks?
-- How many stocks should you own?
-- How do you choose the stocks to buy?
-- When should you buy them?
Asset allocation
How you divide your total portfolio into stocks, bonds and cash investments
will influence your total returns greatly. Over the long-term, stocks have
provided the best returns with the greatest risks. Bonds provide steady
income and should provide for the return of your principal on maturity. Cash
investments, like savings accounts, treasury bills and CDs, have more
liquidity and the lowest risks, but usually with the lowest returns over
time.
Your asset allocation should be based on your time horizon and your
tolerance for risk. Generally, the longer your time horizon and the greater
your risk tolerance, the greater portion of your investments you should
consider for stock investing. However, even young investors should remember
that stocks do not always go up. This is especially important if young
investors may need the funds for some other purpose like buying a home or
funding a college education.
How many stocks?
There is no absolutely right answer. You should own a diversified portfolio
that gives you exposure to the overall market, but not so many that you
cannot do your homework when selecting them or not follow them after you buy
them. You should also make sure to have stocks in a variety of industries so
a slow-down in one segment of the economy does not ruin the return of your
total portfolio.
One rule of thumb to consider is to own at least 3 or 4 stocks in at least
4 or 5 industries. This will give you relatively broad exposure and should
not be so cumbersome that you cannot stay aware of what is happening with
each company.
Choosing stocks
Again, there is no absolutely right answer. Thousands of professional
investors and mutual fund managers spend all their lives trying to choose the
stocks that are going to perform well. Some are more successful than
others.
Ultimately, the value of a stock is determined in the open market by what
other investors are willing to pay. Their opinions are most likely influenced
by their perception of how the underlying value of the company is going to
change in the future. In other words, stock in companies whose income is
expected to rise should be more likely to rise in value over time. Therefore,
the key is to identify companies that are going to be successful.
Unfortunately, that process in not always easy.
You may want to start by selecting industries where the future looks
bright. Companies in those industries are likely to have the opportunity to
increase sales and profits. For example, the outlook for the healthcare
industry is probably better than the outlook for the farm implement industry.
The American public is getting older and needing more health care, while the
number of farms is shrinking and the productivity of farms is increasing.
Then try to identify the companies that you believe will do well in that
industry. The competition in all industries is intense. Companies that are
well run, profitable and gaining market share may be the leaders of the
future. That is not to say that innovative start-ups are bad choices, just be
aware that they may be riskier.
Finding information on companies has gotten much easier over the past few
years. Almost every public company has a website where you can request
information. In addition, many popular websites have money or finance areas
with useful information. If you have a brokerage relationship, you can ask
for research reports. Many public libraries also have reference sources you
may want to check out.
When to buy
It is easy to say, "Buy just before stocks are going to rise."
Unfortunately, no one can accurately predict the short-term direction of the
stock market or individual stocks. To deal with this uncertainty, spread your
purchases over time, perhaps 4 to 6 months. That way you can avoid putting
all your funds to work at the top of a market cycle. If the market goes down,
you will end up with a lower average cost. If the market goes up, you will
have missed some profits, but hedged your risk.
Conclusion
Building a stock portfolio takes time and effort. Do your homework and have
a strategy. Even if you rely on an advisor, remember that it is your money
and the future results will affect your future financial security.
