Most investors have just one goal: to build a portfolio of stocks that can weather any storm and which can also provide a growing, stable income over the long term. Here are a few tips to help you build a financial fortress of your own.
First, keep things simple and stick to what you know. Before you invest, ask yourself if you could explain to a 10 year old what the company’s product or service is and how it makes money. If you want to build your portfolio into a financial fortress, it isn’t going to be filled with esoteric stocks, or small companies that aren’t well established. Speculative stocks should make up no more than 10% of your holdings (see Good things happen to great businesses).
The stocks with the least downside – which are also unlikely to be the ones that could triple overnight – should form the core of your portfolio. These might include stable monopolies like Sydney Airport (ASX: SYD) or ASX (ASX: ASX), the big banks or insurers, consumer staples like Woolworths (ASX: WOW), or large manufacturers and service providers like Ansell (ASX: ANN) and Computershare (ASX: CPU).
Ultimately, you want to own high-quality companies for the long term and buy them when they are trading at a discount to their intrinsic value (that is, you want a margin of safety). Even the best companies will make lousy investments if you pay too much for them. For a list of the stocks we believe are trading below their intrinsic value and offer the best potential for good returns, check out our current Buy list.
Diversify and avoid leverage
Owning solid companies isn’t enough to ensure you have a portfolio that can handle the bad times. To achieve that, you must avoid two things at all costs: leverage and poor diversification.
Leverage in particular can leave your fortress gates wide open to danger by boosting returns in good times – giving you a false sense of security – only to supercharge your losses when something goes wrong. As Warren Buffett put it, ‘leverage is the only way a smart guy can go broke’.
When we’re presented with choices, our tendency is often to try to pick the single best one. But great companies can still run into trouble so if you bet the farm on just a few stocks and one of those stocks turns sour, you may wake up one morning with a much smaller farm. Diversification is arguably the single most important factor when it comes to building a financial fortress.
You should aim to eventually own 10-20 stocks, which provides adequate diversification while also concentrating you in your best ideas.
However, watch out for correlated risks. The benefit of diversification is that it reduces the risk of complete loss of capital. That advantage is diminished when your holdings are exposed to similar industries or risk factors. There’s a big difference between a portfolio of completely unrelated companies like Sydney Airport, Woolworths, Computershare and Ansell, compared to one split between Westpac (ASX: WBC), Commonwealth Bank (ASX: CBA), ANZ (ASX: ANZ) and NAB (ASX: NAB) – all of which would be pummeled if there were a housing downturn or financial crisis. The InvestSmart Portfolio Manager can help you build a well-balanced portfolio using its 'health check' feature to show areas that may overexpose you to certain risks.
To that end, no stock on our coverage list has a recommended maximum portfolio weighting above 10% and no industry more than 20% or so.
No investor wants to go back to square one, and minimising that risk is essential to decent long-term returns. If you avoid debt, and own a diverse portfolio of high-quality, undervalued stocks, you’re well on your way to building a financial fortress.
For more on this topic, see how the same concept can be applied to your personal finances.
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