Every portfolio has a structure. It may be a planned one with thought given to creating a diverse mix of stocks, bonds, mutual funds, and other securities; or it may be unplanned and simply grow organically in various directions depending on buys and sells over time.
The more prudent course is to have a plan, and to follow an investment style that fits your goals, risk tolerance and time horizon. The following tips may add some structure to your portfolio - and help provide some clarity to how a portfolio might be organized and managed.
1. Own a strong dividend paying company in every market sector.
Dividends, and the potential for growth in a stock, are hard to beat. You get paid every quarter, and you get the possibility of price appreciation over time. Every sector in the market has strong companies with a history of paying and increasing dividends. These companies are often held as core positions - owned over long periods of time as they have proved themselves to be stable dividend payers with steady (but probably not spectacular) growth. These are companies, in some cases, to grow old with.
Examples are stalwarts such as: Procter & Gamble (NYSE:PG) yielding 3.1% in consumer goods; Johnson & Johnson (NYSE:JNJ) yielding 3.1% in healthcare; Intel (NASDAQ:INTC) yielding 3.7% in technology; Pfizer (NYSE:PFE) yielding 3.4% in pharmaceuticals; Chevron (NYSE:CVX) yielding 3.3% in oil/energy; Halliburton (NYSE:HAL) yielding 2.1% in oil services; DuPont (NYSE:DD) yielding 3.2% in chemicals, Duke Energy (NYSE:DUK) yielding 4.5% in utilities; Verizon (NYSE:VZ) yielding 4.1% in telecommunications; and Raytheon (NYSE:RTN) yielding 3.3% in defense. There are, of course, many additional worthy companies in each of these sectors and in others.
These core holdings, and the sectors they are in, will rotate in and out of favor over time with the economic cycle. But they will regularly throw off dividends to their shareholders, and they have a history of rewarding long-term holders with growth as well.
2. Own a strong dividend paying company/security in every asset class.
In addition to domestic stocks (U.S. equities), there are REITs, MLPs, emerging market ETFs, developed market ETFs, and mutual funds of virtually every type paying dividends. Owning a position in these additional areas increases the diversification of a portfolio and, again, taps into the regular payment of dividends with the potential for long-term growth.
Examples are: Realty Income (NYSE:O) yielding 4.9% in REITs; Kinder Morgan (NYSE:KMP) yielding 6.1% in MLPs; MSCI Pacific ex-Japan (NYSEARCA:EPP) yielding 4% in emerging market ETFs; and MSCI EAFE Index (NYSEARCA:EFA) yielding 2.9% in developed market ETFs. Many index mutual funds also hold baskets of companies in various asset classes paying dividends, for example: Vanguard REIT Index (MUTF:VGSIX) yielding 3.2%, and Fidelity Real Estate Income (MUTF:FRIFX) yielding 4.3%.
3. Let no single position exceed 5% of your portfolio.
Position size is one way investors may choose to over or under weight a given sector, industry or area of the market. Overweighting may lead one to hold a single large position in one stock in a sector, or a few significant positions in different companies occupying the same sector.
Excessive under weighting of a sector (or being completely out of a sector or industry) is not a problem - but being excessively over weight in any one position can be a disaster. The most commonly cited examples of this are people who had the bulk of their holdings in the stock of the company where they were employed - Enron, or Lucent, or Nortel come to mind. But this can happen any time there is an over concentration in any specific company or sector when the market - or some event - goes against that concentrated position.
The most prudent course is to keep the size of individual positions limited to 5% of your total portfolio. And if the market takes a position or holding over the 5% mark, discipline calls for it to be trimmed back.
4. Have and maintain a long-term time horizon - until age/health cause you to shorten it (then move to safer, less volatile assets).
History shows that the best path to safety in the market is a long-term time horizon. In the short term the market can do anything - and often seems perversely to do just the opposite of what most people expect it to do. But in the long term (a period of 15 or more years), the market has historically been a reliable way to grow wealth. Adopt Warren Buffett's philosophy - be an "owner" of companies and share in their growth and position in the marketplace over time.
When age or health, or some other need, shortens your time horizon - shift farther away from equities to safer, less volatile assets. Without time, the ability to recover from a bad event in the market (which can come at any time) diminishes and the risk/reward equation for being in equities changes.
5. Invest - do not trade frequently or try to time the market.
Despite all the commentary in the financial press about which way the market will move and why, no one really has a clue what direction it will go in the next week, month, or year. Putting money down on a guess as to which way the market will go is not a sound financial plan. It is gambling. Occasionally, with all the market calls that get made daily, someone gets lucky - but no one is reliably good at it.
Investing, with its longer time horizon, takes the guesswork on market direction and timing out of the equation. We know the market will rise and fall. We know our positions will do the same. We stay invested in solid companies and let their products and services create earnings to drive their stock price over time (and at the same time collect a dividend from our dividend payers).
6. Beware of letting short-term fear or market volatility violate your investment plan.
Every year there are days the market will sink like a stone. These declines may last only a few days or they may go on for weeks and months and develop into a full blown bear market. It is easy to get caught up in the fear and panic as seemingly everyone dumps their holdings to get out. Margin calls get made and the selling accelerates - in the rush to liquidate no sector or asset class is safe except for cash.
These are the most difficult times for the individual investor as fear is everywhere and the wounds from the 2008/2009 bear market are still fresh.
And yet, despite this pain, history has shown that given a longer term time horizon, the market has always come back. So far, always. This longer term time horizon is a vital part of the safety net for your investment plan. It can be the hardest thing to do in the fear and panic of a market that is shrinking your portfolio every day, but think hard before abandoning your time horizon safety net.
7. Trim some positions if they become significantly overvalued relative to their historic PE ratios vs. what the S&P is trading for, or if they become too large a percentage in your portfolio - and add to such positions when the market moves to misprice them too cheaply.
We all know that the market periodically misprices certain stocks and/or sectors at times. The recent run-up of high yielding dividend paying stocks is an example. Facing the past few years of depressed yields in the cash and bond markets, investors poured into dividend paying stocks in search of yield. As a result, many companies enjoyed significant price appreciation and their PE ratios grew not only beyond their historic norms but beyond the average PE for the S&P.
When this happens, consider trimming some of these positions back to capture these outsized gains. The market will eventually rotate to another sector and these stocks will come back down. If they come down too hard and become cheap (or at least return to normal valuation levels) refill the position you trimmed.
8. Know your risk tolerance and don't take on more risk than necessary to meet your goals.
For most of us, investments are our ticket to retirement. We work and invest our whole lives to create the assets that will see us into and through our retirement years. Some of us have a higher or lower tolerance for risk than others. Those who want safety and place a premium on preserving their capital should be in investments with little or no risk. Those who can tolerate risk are more comfortable in equities - and are likely to have a mix of investments all along the risk curve. Know what your tolerance for risk is and invest accordingly.
If you are fortunate enough to have met your financial goals, beware of taking on more risk than you need. I once heard a financial advisor tell an investor who had met (and exceeded) his financial needs for retirement: "Now that you have met your goals - don't screw it up." Having achieved that status, the last thing you want is to have some risky move take you back below where you need to be.
9. Hold only one or two (if any) speculative positions and don't let the total of them exceed 5% of your portfolio.
It's no secret that young, new companies starting out have a higher risk/reward profile than a mature, older company now paying dividends. Starbucks (NASDAQ:SBUX) was once a new, almost unheard of company in the relatively small market of Seattle hoping to change the way people looked at and consumed coffee. In its infancy it was a speculative bet that a small coffee chain could take on the giant companies that virtually owned the coffee market selling established name branded coffee the past several decades.
Starbucks is a great example of how an early speculative bet on a new company can pay off. However, for every Starbucks, there are scores of small companies that don't make it. The risk of investing in a new, speculative company is high - just as the reward is high if the company succeeds. But because the risk is so high, it is best to limit speculative plays in a portfolio (if any) to one or two.
Investing is not a get rich quick scheme. It is okay to swing for the fences occasionally. But prudent management of a portfolio requires that speculation be limited and not allowed to exceed reasonable limits to keep it in its place. Maintain an emphasis on solid, long-term companies that will do well over time.
10. Keep some dry powder (CASH) to take advantage of panic corrections that go too far taking all sectors and asset classes down at the same time.
When a buying opportunity presents itself, you don't want to have to sell one position to take advantage of another. Keeping some cash available and on hand allows you to add to existing positions when the market makes them too cheap, or to add a new one when the right opportunity arises.
The amount you keep on hand will depend on the overall size of your portfolio, but it should be large enough to allow you to act on several stocks in the event of a general market decline taking everything you own down at once.
These tips are not hard and fast rules - they may fairly be regarded more as guidelines designed to give your portfolio a planned structure you can understand and control. And they can help create some clarity and focus on selecting solid companies that have successfully weathered recessions and bear markets and prospered over time.