It can be extremely tempting to try to buy and own a piece of all the stocks making headlines. The hottest themes heading into 2021 like electronic vehicles (EV), rare earth elements (needed for EV batteries), clean energy, iGaming, bitcoin and special purpose acquisition companies (SPACs) often trigger impulse trades often at the worst prices (highs). However, the most prudent thing to do is to avoid the “urge” to chase the “hottest” stocks because chances are you are experiencing the fear-of-mission-out (FOMO) which turns investing into a game of musical chairs, whether you know it or not.
When asked what your investment goals are, the obvious answer is “To make profits, duh!”. However, that’s the surface level response on the same level as impulse trading. The real question is not just what your investment goals are, but how much risk you are willing to endure to reach those goals. Risk is exposure both in terms of position allocation and holding period. On the surface level, risk is simply how much “pain’ you can you stomach when your position go in the red (and deep in the red)? Everyone is a cool hand when their stocks are rising, but it’s a whole different story when they are sinking. With that in mind, let’s break it down into two parts.
Define Your Investment Goals
Quantify your investment goals by percentages. Keep in mind, the higher your percentage goal, the more risk you need to be willing to take. For example, if you want a 10% return, are you willing to stomach and risk a (-20%) loss? This is to test your risk tolerance (pain) threshold. If you truly are willing to take that kind of a pullback then you’re risk tolerance is may qualify. To temper the pain, you should also ask yourself what is your holding time horizon? Short-term is a matter of days. Medium-term is weeks to longs. Long-term is years. The longer your time horizon, the more you can buffer some of the risk.
Diversification Buffers Risk
To further buffer your risk, you should diversify your portfolio amongst different sectors and industries. There are 11 sectors in the S&P 500 index. You can spread the investment into multiple sectors or if you are very proficient in fundamental and technical analysis, then you can look to specialize in one or two specific sectors and industries. It boils down to how active or passive you will be with your portfolio.
Start By Investing In Companies You Like
Familiarity is the initial step. Be familiar with your stocks. If you are an end user to a service or product that you absolutely like, then research the company and familiarize yourself with its business model. Identify those companies that you are intimately familiar with as a consumer, study the fundamentals and technicals. Then consider investing in them. If you like 10 companies or 5 companies, spread out the risk by investing in more than one. Never put all your eggs in one basket! Diversify as you go.
Diversifying Your Portfolio
Diversification is a word you hear constantly when it comes to stock investing. Diversification means to spread out your risk by investing in multiple different sectors and industries. Of the companies that you like and are familiar with, start to determining which sectors and industries they are in. If you have two companies that both sell athleisure and sports apparel, then select one. Try not to have the same companies in the same sector and industry as they tend to move together and that defeats the purpose of spreading your risk.
How To Diversify Properly
Determine your total portfolio allocation capital amount to stocks and then split that up into equal parts percentage wise. Be familiar with the 11 different sectors and the industries within them. Research how certain sectors historically correlate or diverge with other sectors. For example, utilities tend to rise in falling markets, but not always. Allocation percentages to the sectors and then add the stocks accordingly. Make sure you are familiar with the underlying companies. For example, allocating 20% of your stock portfolio between information technology, consumer discretionary, healthcare, financials, and utilities is a good start. Then you can populate them accordingly to sector and/or industry. If you can’t think of any stocks for a particular sector, you can always use a sector, industry or theme bases exchange-traded-fund (ETF). You can adjust the allocation percentages throughout the year and rebalance as needed.
Benefits Of Diversification
When you diversify, you spread out your risk by giving yourself broad exposure to multiple sectors and industries. The portfolio can be less volatile enabling a more passive approach if you have a long-term time horizon. However, keep in mind this applies in rising markets. Falling markets can be a different story, therefore it’s important to adjust allocation to stocks versus fixed income instruments throughout the year.
Downsides Of Diversification
While the volatility may be less, the upside is also spread out. By spreading out the risk amongst different sectors can buffer reversions and turbulence, a full fledged bear market sell-off can hurt your across the board. Therefore, diversification is not risk-free. The upward gains will be smaller, but the downside pain should be less as well. In uptrending markets, you will accumulate profits and should expect drawdowns in falling markets.
If you are willing take on more risk for more gain, then a specialized investing approach may be for you. This is where you concentrate your portfolio around specific sectors, industries or themes, rather than diversifying broadly across different cross sectors. For example, you may be very familiar with electronic vehicles (EVs) or clean energy and decide to build your portfolio around this theme.
Benefits Of Specialization
Specialization concentrates your investment around specific sectors/industries or themes. It’s more risk but can potentially offer more reward. It enables you to focus on quality over quantity and maximum upside potentially. However, it takes active research, analysis and trade management. This doesn’t mean jumping head first into any momentum stock and hoping it goes up. You should be invested in effort just as much as cash. You should know the current earnings and expectations as well as the longer time price trends and patterns of the underlying stock.
Downsides Of Specialization
The downside to specialization is really putting most of your eggs in one basket. If you’re research and analysis is off, you can get pounded. If you are passive and don’t bother to stay on top of the news, catalysts and charts, then you are asking to get nailed when sentiment turns negative. Specialization should be limited to seasoned active investors. If you aren’t one, then start with diversification.
How Many Stocks Should You Own?
This depends on how many stocks you are familiar with and whether you are going to diversify or specialize. If you have to ask how many stocks should be in a portfolio, you are probably new and should start with diversifying. Filter down the stocks you know to a handful. Split the allocation evenly to diversify. Newbies should start with no more than five stocks spread across different sectors and industries based on the portfolio size. This doesn’t mean to invest your full portfolio split between a handful of stocks. Keep in mind that cash is a position as well.
Always leave cash so that you can dollar-cost-average into positions. Smaller portfolios tend to benefit more from specialization while larger portfolios benefit from diversification. The larger your portfolio is, the more it can benefit from diversification (IE: a $1 million portfolio vs. a $1,000 portfolio). As you build up your portfolio, spread out the risk with diversification.