No one will care about your money more than yourself.
Therefore, for my family, the role of capital allocator falls squarely on my shoulders.
Capital allocation is a skill that you can acquire over time, through experience and learning from mistakes.
Some may argue that it’s a skill that can be picked up from books and articles.
But I beg to differ.
Portfolio construction is a dynamic process that needs to be reviewed and tweaked constantly.
Books may provide a useful framework, but the subsequent adjustments and tweaking need to be based on both the economic climate and how the companies themselves perform.
A personal endeavour
Admittedly, the topic of portfolio construction is a tricky one.
Ask anyone out there about how they think a portfolio should be built, and chances are you will get a myriad of responses.
There are, to be frank, no right or wrong answers.
Investing is, after all, an intensely personal endeavour.
Each person has their own goals and objectives.
For instance, some investors may want to grow their retirement nest egg through capital growth.
Another group of investors may seek a regular flow of dividend income to sustain them through their golden years.
Yet another group could be building up an education fund to send their young kids to university in a decade’s time.
In essence, your personal goals will influence how you construct your portfolio, whether it be tilted towards growth, income or a combination of both.
It will also govern how much risk you are willing to take.
Building your own stock portfolio
It’s perfectly normal to make mistakes when investing your money.
In fact, I have made my fair share of investing errors.
Instead of treating these mistakes as a setback, you should distil valuable lessons from them to strengthen your investment process.
I make it a point to document all my buy and sell decisions on every stock. When something goes wrong, this practice makes it easier to conduct a post-mortem to find out what went wrong.
If you follow what I do, you can slowly but surely refine your investment process accordingly.
This refinement involves reducing the weightage for stocks that are more speculative and increasing your capital allocation in companies with stable, rock-solid financials.
Several other notable aspects of portfolio construction should also be taken into account, such as position sizing, industry diversification and geographic diversification.
How much should you buy?
Choosing a good company is just the start.
It’s equally important to know how much to allocate to each position.
In other words, it’s not just what you buy, but how much of it that counts.
Peter Lynch, a well-known ex-fund manager of Fidelity Investments, once said that getting six out of 10 investments right is a good achievement.
But let’s drill down into the matter a little further.
Assuming you can get six out of 10 investment picks right, how much money can you make?
What will your returns be?
An investor should always ask himself how much he can make when he is right, versus how much he may lose when he is wrong.
Investing deals with a range of probabilities and a future that is uncertain.
No matter how good your analysis may be, luck still plays a major role in determining investment outcomes.
It is, therefore, important to ensure that you allocate less of your money to riskier, speculative positions, even when they promise significant upside.
The converse is also true.
More of your money should be parked in businesses with strong competitive moats and stable financial characteristics, even if the growth rate is less exciting.
Industry and geographic diversification
Diversification is an often-touted virtue that helps to lower overall portfolio risk, though detractors also point out that doing so will dilute overall returns.
Your portfolio does need adequate diversification in terms of both industry and geography.
This setup helps to mitigate the risks of a blow-up within a single sector or region.
Industry diversification helps you spread out risk while allowing you to participate in the growth trends afforded by these industries.
A smattering of industries such as electronics, consumer goods, engineering, banks, real estate, and services provides the portfolio with exposure to many promising industries, yet mitigates the risk of a blow-up in any single sector.
Beyond industry diversification, you may want to consider businesses that are exposed to different regions of the world. By doing so, it reduces country-specific risks, including politics and regulations.
An example of country-specific risks rearing their ugly head occurred with Food Empire (SGX: F03) around five years ago. The group has significant exposure to Russia and Ukraine as its business involves selling 3-in-1 coffee and other packaged beverages to these markets.
Food Empire recorded large losses when the Ukrainian Hryvnia declined from 15.8 to 23.9 to the US dollar and the Russian Ruble weakened from 56.3 to 72.9 during the same period.
Being aware of the lack of geographical diversification is key.
Keeping cash handy
It may be surprising to learn that cash itself plays an important role when you construct your portfolio.
Cash, in this case, refers to funds available for investment.
The availability of cash opens up opportunities to pounce when valuations fall steeply and stock markets plunge by 50% or more.
Such instances are rare though — occurring, on average, once per decade.
The most recent market crash occurred during the 2008-2009 Global Financial Crisis, while the current COVID-19 pandemic has led to the swiftest stock market crash since the Great Depression.
Retaining a small percentage of your portfolio, say around 5% to 10%, in cash will enable you to take advantage of opportunities to load up on shares of strong companies when a crash happens. The cash could be used to take up new positions or average down on existing positions.
That way, you won’t just sit by and watch helplessly as valuations spiral downward without being able to participate.
A slow and steady learning process
There are no shortcuts when it comes to portfolio construction.
The process of allocating capital efficiently and ensuring adequate diversification takes time, and experience.
Investing, after all, is a marathon and not a sprint.
Take your time to learn slowly and steadily. Do not be afraid to make mistakes. But try to keep these errors small as to not damage your investment portfolio by too much.
With luck, it will take several years to construct a robust portfolio that can stand the test of time.
What I will guarantee is that the process will be both financially and psychologically rewarding.
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Note: An earlier version of this article appeared in The Business Times.
Disclaimer: Royston Yang does not own shares in any of the companies mentioned.
