Investing for beginners #5 – Portfolio and Strategy basics

Portfolio basics

So, you’ve signed up to an investing platform, got your finances in order and are ready to make that first stock purchase! Awesome! But what do you buy first? How much of it should you buy? Should you buy UK or American? 1 stock or a hundred?

The stock market can be a confusing place, so in episode 5 of investing for beginners, we talk portfolio basics. These strategies are proven methods to give beginner investors confidence when buying and to protect their money. We’re going to cover what we think is the right amount of stocks, how much you should invest, whether you need to look at funds and when you should buy. Let’s jump in!

Rule 1 – Only invest money you can afford

In the early stages, its easy to get excited by rising values which can lead you to want to invest more and more, perhaps even money you had put aside for emergencies, or money you’ve been saving for upcoming home improvents etc.

This would be a mistake. When you hear people say ‘only invest money you can afford to lose’, what they really mean is only invest money you can afford to leave invested for the long term. We never really expect to lose the money that’s invested (though this can occur, especially if your strategy is poor!), however to do investing right, you need to be prepared to leave your money invested for 5+ years and the longer you leave it, the better.

This is because, even though the stock market trends upwards (between 7-8% globally on average), lengthy lows that can last years are not uncommon. When this happens, its important that you’re invested for the long haul so that you can ride out these dips. If for instance you’ve invested your emergency fund and lo and behold, there’s an emergency, you’ll need to liquidate your portfolio to extract the cash if you have no other option. The problem here is, if the market is in a dip, you end up losing money and in the worst case not be able to cover the emergency. Be prepared to invest and keep it invested!

Rule 2 – Diversify

“Don’t look for the needle in the haystack, just buy the haystack!”.

John Bogle

The best way to learn the ropes of investing is to learn by doing. The problem here is, you don’t really want to learn the ropes by losing your hard earned cash on day 1! To create a stable base for your portfolio, we would recommend making it fairly diverse so that it covers many global markets. Did you know that 89% fund managers fail to beat the market every year? You read that right. 89%. These guys are professionals and 9 out of 10 fail to beat the market they are being benchmarked against. However, forward thinking cheapskates know, you can’t underperform the market if you own the market!

Look to ETFs

An easy way to instant diversification and to own the market is to purchase ETFs. An ETF is basically a collection of stocks. The stocks in the ETF are usually grouped by industry, index or some other parameter. For instance, if you wanted to invest in the companies of the FTSE 100, you would invest in a FTSE 100 ETF that tracks the price of the entire index, instead of having to invest in each of the 100 companies individually (which would be a logistical nightmare to do properly). You do pay a charge for this service (usually around the 0.1% mark, but some of the best ETF’s have fees as low as 0.05%!) but we feel this is more than acceptable to get that instant diversification that will help you protect and grow your investments. We talk about different ETF’s in the next article, but if ETF’s aren’t for you then you should at minimum think about spreading your investments across different companies and geographies to ensure you’ve got exposure to different markets and business types.

Doing it this way at the beginning takes the guess work of picking stocks out of the equation and allows you to benefit from the growth of the markets at large. Like we said in previous articles, speculating on a single stock that might double or triple your money can work, but over time is a surefire way to zero. Getting a decent growth and compounding it over time is our preferred method (not that we don’t like a dabble on the risky side now and then). Think that the UK stock market will rise? Why not invest in a number of FTSE 100 companies or a FTSE 100 ETF? Think that healthcare will increase in demand over time because the population is getting older? Try a number of healthcare and pharmaceutical companies. Want to diversify your portfolio to the point where you’re invested in all of the large companies on the planet. You guessed it, there’s an ETF for that. As you get more proficient and learn the ropes, there’s nothing stopping you from adding some speculative stocks to your portfolio and maybe some exchange traded commodities like gold. Fingers in pies.

For starting out, we would allocate most of the portfolio to ETFs or a diverse collection of stocks and shares that cover the broad markets or the world (if you don’t know what size the economies of the world represent in the global economy, you can buy a global etf!). Be sure to include large caps, small caps and different industries so that you can benefit from the global growth.

Rule 3 – Don’t lose money

“Rule No. 1: Never lose money. Rule No. 2: Don’t forget rule No. 1”.

Warren Buffet

On the face of it, the quote above sounds obvious, maybe a little too obvious, but beneath the surface of the quote is an important message. The reason Buffet tells us not to lose money, is because losing money has a bigger effect on investments than gains. The reason for this is that once the money is lost, it becomes increasingly harder to make the money back. Take this example:

If you want to make £200 on a £1000 investment, you’re hoping for a 20% increase. Easy. But let’s say you lost £200 first putting your value at £800, you now have to increase your imvestment 25% just to break even, and would need to make 50% to make that extra £200 you set out to achieve, a much bigger challenge than scenario 1.

But isn’t it impossible not to lose money?

Unfortunately yes, its basically impossible not to lose some sort of money when trading in the stock market but there are ways to minimise this and ensure your portfolio is consistently in the green. The opposite to having a diverse portfolio in rule 3 would be to have a portfolio with just a few single stocks, with those stocks controlling large percentages of your allocation. The more percentage single stocks control, generally speaking the riskier your investment is. That’s because, while entire markets can move up and down, their movements usually pale in comparison to the price movements of stocks. Stocks can be influenced by more factors like poor press, poor earnings reports, scandal, management etc which can dramatically affect its price quickly, so you want to keep your holdings in single stocks to a minimum.

Of course, you can use this to your advantage as the prices of stocks can explode upwards quickly but it can also work against you by crashing downwards and taking your portfolio with it. To do stocks properly takes time to learn how to pick stocks and read the fundamentals of a company, so as a beginner, we say try to stick to 10% or less of your portfolio being allocated to stocks. This helps guard against losing big sums of money.

Rule 4 – Use DCA (Dollar cost averaging)

Earlier we said that even the average growth of the global market, compounded over time can net you some real juicy returns. Problem is, getting a good return can only be achieved if you buy at a good price. How do you know if a price is good? what if the price of something drops tomorrow, or next month? Fear not, there’s a strategy for this: Dollar cost averaging.

You may have heard people talk about this method, but essentially all this means is buying stocks consistently, regardless of their price. That way, you’ll be buying the stock when its high and you’ll buy it when its low, which should average to a fair price over time. The average price you buy at will be higher than the absolute lowest point but it will be lower than the highest points. It’s pretty common for stocks to have high spikes in their price, so using the DCA method can ensure you avoid them. Example:

Lets say you have £1000 to invest in a FTSE 100 etf. Today’s price looks good, but it might decline for the next 10 weeks. Why not divide that £1000 into 10 x £100 and invest it over 10 weeks. That way, you’re more likely to have bought at a fair price for the next 10 trading weeks.

Cheapskates can take it further

As cheapskates, we love a bargain, so we take the dollar cost averaging method and tweak it a little. The more you invest and monitor your investments, the more you will get a feel for good prices and bad prices. When we see that the price has fallen a little, we invest a little more, and if it takes a sharp rise, we would invest a little less. Timing the market isn’t an effective strategy, so we don’t do this if the price heads in the same direction after the second week and we certainly don’t do this with single stocks, but with large index tracking ETF’s it can make a difference. But remember:

“In the long run it doesn’t matter much whether your timing is great or lousy. What matters is that you stay invested

Louis Rukeyser

Rule 5 – Time in the market beats timing the market

By now, you’ve probably guessed that our investing approach is geared for the long game but we would just like to hammer it home – buy it and hold it. As a new investor, its really easy to check your investments daily and to despair over one of your stocks falling by 20%. Make no mistake, this WILL happen. Even the world’s best traders and investors get their fair share of collapses. Too often people will hear about the market downturn in the news and think , “I need to get out now and protect my money!”. Problem is, loads of other people will have had the same thought, probably a lot sooner than you.

“As a rule of thumb, if you’re hearing about stocks and shares in the news, you’ve already missed the opportunity”

Dan

These investors end up selling their shares for less than they are truly worth in order to protect their investments. What then makes matters worse is they are afraid to invest back into the market and don’t end up investing until the price is high again! Don’t do this, as emotional investing is a surefire way to kill your portfolio. The best policy for investors we feel is to hold. As long as you can hold for long enough (are not retiring soon) then holding is almost always the best policy when it comes to the markets ups and downs. As we said previously, buying and holding a diverse range of stocks beats actively managed funds almost 90% of the time!

So, how long do I hold for?

Forever! Theoretically anyway but if you cant hold for more than 10 years then it may not be best for you to be investing this way and to look at a more solid type of guaranteed return investment (like bonds, p2p lending or savings accounts). Time in the market always beats timing the market and the more time you can give it, the more you’ll be able to smooth out the bumps. We are investors, not traders and its important to learn the distinctions. Traditionally, a trader is someone who’s looking to make a profit in a short timescale, investors are looking to make large gains over time. Investors never sell, but traders never win.

So there’s no best time to buy?

Not exactly. Someone once told me, the best time to buy is 10 years ago, the second best time is now! What this means is there’s no time like the present. As we mentioned in lesson one of this series, the best weapon in an investors arsenal is TIME. Don’t put off investing, waiting for the best time to invest as it may never come. Use the guidelines above and start making those investments today, the sooner you start the better.

Next Up…

Thanks for reading! next up in our investing for beginners series we talk about making that first investment and specific stocks and shares!

Let us know your thoughts by leaving a comment below!

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