Tips on how to build a stock portfolio

As anyone who has followed the British boy-band One Direction knows, it is entirely possible to significantly increase the odds of building a successful pop band by using a formula even in a cluttered music market. To some extent, the same concept holds true when building a stock portfolio despite the unknowns of the investment market and geopolitical events.

In the case of One Direction, the group was created using key “ingredients” that frequently help to drive success:  take five clean-cut English and Irish lads, audition them to ensure they have the right voice, add some lyrics heavy on puppy love, apply skinny jeans (the proper fashion touch) and serve.  The result: A global pop phenomenon.

Key factors for building a stock portfolio

The same kind of design efforts may pay off for a stock portfolio. Just like in pop music, there are certain factors of an investment that can help to meet portfolio outcomes. Stocks with these key factors may be additive in any portfolio. So what are these key factors?
Let’s talk about four factors that we think are necessary when constructing a stock portfolio:

1. Value. This is defined as buying stocks that are undervalued – in other words, cheap. People behaviorally are subject to the “lottery effect”; basically they overestimate the likelihood that unlikely events will occur. As a result, they prefer to buy stocks that present the possibility for them to “win big”.  This preference, in general, pushes the price of these stocks higher than they should be based solely on fundamentals (as it is unlikely that all of these stocks will win big). There’s also a bigger penalty for being wrong when a stock is overpriced compared to being wrong when it’s underpriced.  Avoiding such unbalanced scenarios when choosing stocks is key. Those looking for bargain stocks - stocks that are underpriced or “out of favor” despite solid fundamentals - know the impact that avoiding their natural human behavioral bias can have on a portfolio.

2. Momentum. People suffer from a herd mentality in many aspects of life and investing is certainly no exception. As a result, they often tend to pile into stocks that are going up and sell those going down. In simple terms, they buy high and sell low. Momentum investing works exactly because of this phenomenon as you follow the herd. The difficulty is that when momentum stops working, it can be very painful (and hard to time). Pairing momentum and value investing together can help to manage the risks of experiencing the more difficult aspects of momentum investing. While risky, momentum is a factor that may be used judiciously when managing a stock portfolio.

3. Size. This factor is a little more complicated. The main opportunity smaller cap stocks present is that there are more of them relative to large cap stocks and many of them are relatively unknown to even sophisticated investors. As a result, the impact of the lottery effect and herding behavior are potentially even greater. This quantity and diversity represents a real opportunity to add value in building a portfolio. Of course, these types of stocks, given the factors that make them attractive, also tend to be riskier than other types of stocks. They need to be evaluated judiciously, as part of a total portfolio approach.
4. Quality. These stocks can be seen as the “safe and boring” types because their prices are generally less volatile than others. These companies are often ignored by the market until the economic roof caves in (think 2008), when safe and boring is ALL the broad market wants to own. Quality is often underappreciated and undervalued, thus making it attractive as a source of potential incremental returns for the investor who understands that boring can be lucrative. Like the tortoise in the children’s fable, the power of compounding returns often means slow and steady wins the race.

While formulas are often derided as unoriginal, they exist (and work) for a reason. Whether one is building a boy band or a stock portfolio, paying attention to a formula of investment factors may help to increase the odds of building wealth that lasts. But, there’s still one factor left…call it the “X” factor. We’ll get to talk about that in my next post. In the meantime, you may want to read a recent post by my colleague, Jeff Hussey, on the importance of a diversification in a portfolio or watch this interview with CEO Asia-Pacific, Pete Gunning about multi-asset investing in a volatile investment landscape.