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How to Build a Stock Portfolio that Produces More Competitive Returns

02/14/2019

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When investing, everyone wants to see the total value of their portfolio grow. Some investors may be content with steady growth that outpaces inflation and fees paid to invest while others may want to see returns that beat some of the best portfolios available.
In either case, achieving those results requires learning how to build a stock portfolio that can deliver competitive returns. After all, why build a portfolio when there are funds that have been shown to provide small but steady gains?
This article is meant for those who want more than just small, steady gains. For those who want to discover how to build a stock portfolio that delivers exceptional results, there are some tried, tested, and true methods for approaching portfolio construction.
Here are some of the considerations that the best investors in the world take into account when designing a portfolio built for performance.

Look for Small Companies to Grow

For many investors, investing money in shares of well-known, large companies feels like the safe, smart decision. While this is not untrue, that strategy will not deliver competitive returns that will put a smile on your face.

Instead, many investors look for smaller companies that have the potential to grow share price. These companies are referred to as small cap stocks.

Publicly traded companies are generally put into 3 categories: small cap, mid cap, and large cap. This refers to market capitalization which is, essentially, the total value of the company. Market capitalization is calculated by multiplying the number of outstanding shares by the price per share.

Large cap stocks are the biggest companies in the market and generally have a market capitalization of $10 billion and higher. Many of these companies are well-known, household names like Apple, Walmart, and Verizon.

Small cap stocks are companies that have a market capitalization of less than $2 billion. These could include some very well-known established companies as well as up-and-coming companies that are primed for growth.

So, why are small cap stocks a good investment for investors who want competitive returns? These companies have more opportunity to grow revenue and, in turn, grow share prices. Large cap stocks, on the other hand, are already well-established with significant annual revenue numbers. It’s much easier for a small cap company to double revenue than it is for a large cap company to do the same.

Find Low Volatility Stocks

There is a very common misconception that high volatility equals higher returns. This is not always true. Volatility works both ways and, with some very volatile stocks, investors could miss out on significant gains simply due to timing. You know what they always say about timing the market…

In fact, some researchers set out to see if higher volatility truly deliver better results over time when compared with lower volatility portfolios. Their findings discovered that, over time, low volatility portfolios outperformed higher volatility portfolios by a significant margin.

This flies in the face of what is commonly accepted in the investing world regarding how to build a stock portfolio. Investors believe they need to take on significant risk to earn significant gains.

The reality may actually be that low volatility stocks are the better choice for investors who want to show competitive returns.

Why do these more predictable stocks outperform their more volatile counterparts? There are a number of guesses as to why this may be but, unfortunately, there is no hard data.

One answer could simply boil down to investor behavior. Investors believe they need to chase volatile stocks in order to earn gains – which only feeds more into the volatility of these stocks.

Meanwhile, less volatile stocks are ignored and free from the volatility that can come with speculative investors chasing the next big lotto ticket, so to speak.

There is also the simple fact that volatile stocks may show incredible growth during bull markets but end up losing much of those gains during a down market. Rather than trying to time massive swings in either direction, investors may see better performance by simply holding onto less volatile stocks that are better able to weather market downturns while also enjoying steady growth during bull markets, even if that growth is less significant than more volatile stocks.

Finally, by buying and holding less volatile stocks, there is less need for frequent trading. Investors who are trying to play volatile stocks by timing the markets inevitably make more trades and incur more fees than investors who are content to buy and hold. In addition to trading fees, investors that are regularly trading may be on the hook for capital gains taxes which could eat into their overall investment performance.

Rebalance Portfolios with the Business Cycle

Many investors like to take a “buy and hold” strategy which is, for the most part, a smart way to invest. This reduces potential fees and taxes that could result from frequently selling assets in order to chase the next golden goose.

However, simply buying and holding forever with no intention of changing strategy may be a poor strategy. The reality is that some companies are better suited for different periods of the business cycle than other companies. Regular portfolio review and rebalancing during the different phases of the business cycle could be a great way to outperform other investment strategies.

Rebalancing is not a new concept in investing. Investors rebalance portfolios as they near retirement to reduce risk, fund managers rebalance to ensure that their fund’s holding reflect the stated goals of the fund, and some investors even rebalance as the economy changes.

There are four main parts of the business cycle: peak, contraction, recession, and expansion. There are many factors that go into determining what stage of the business cycle the economy is in including unemployment, housing starts, stock prices, prime rates, lending activity, and more.

So, how can investors use these stages of the business cycle to their advantage when determining how to build a stock portfolio? By choosing stocks best suited to each stage of the business cycle, investors can reduce downside risk and increase upside potential.

For example, during the peak phase, the economy has begun to show signs of slowing down. Unemployment is low, stock prices are high, interest rates have risen, and the next stage of the business cycle is inevitably around the corner. This is a great time to unload more speculative stocks and purchase shares of companies that are considered a necessity regardless of how well the economy is doing. Examples of this could include healthcare stocks, energy stocks, and consumer staples or retailers that sell consumer products at a low price rather than more upscale retailers.

If, instead, the economy is in a growth period then investors may look to other stocks like consumer discretionary companies or technology companies that tend to grow more rapidly. These are not stocks you would want to hold through all stages of the business cycle but they do offer the most potential when compared with other industries.

Capture Ratio to Capture Performance

Capture ratio is an interesting investment concept that basically outlines how much an investment has outperformed an index, for example. The reason that this is beneficial to track and follow is because it can indicate which investments offer enough upside performance to help weather downturns.

There is some math that goes into capture ratio but, essentially, it boils down to making money when times are good so that the losses are minimized over time. If you think about it, this makes perfect sense.

Pretend that an investment has outperformed an index by 10% in a bull market. Everyone is gaining but this particular investment has gained more than comparable investments. Therefore, this investment has more buffer room in a market downturn before it has eliminated its gains.

In addition, if the investment has consistently outperformed an index, then it would stand to reason that it will continue to outperform the index even in a down market. This means that the investment in question will have less required growth in order to recoup losses due to a market downturn.

Investors should look for investments that offer this kind of performance. The good times will be very good and the hard times will be softened by earlier gains as well as reduced losses when compared with appropriate index investments. Therefore, investors should be able to be back into a growth phase faster while other investors may have to wait longer before they have made back the gains they lost in the market downturn.

Never Forget Diversification

Diversification is a common theme in investing and for good reason. A diversified investment portfolio allows investors to spread out risk across a wide range of companies and industries. This helps limit the potential shock that can result if a specific industry were to see hardship.

Investors that fail to diversify their portfolios may see significant gains while the stocks or industries they are invested in are doing well. However, their losses may be massive should their overexposed position experience a significant downturn.

There are real life examples of this like in the tech bubble of the late 90’s and early 2000’s. Many investors saw the massive growth of tech companies and chased gains in speculative investments.

When the tech bubble burst, the entire stock market lost 10% value in a very short period of time. The tech industry was devastated and investors who held much of their holdings in this one industry lost much of their portfolios. For some who invested in companies that did not escape the death grip of the tech bubble, their investments may have been entirely lost.

This is a cautionary tale that goes to show any hot industry could be due for a correction. Diversifying a portfolio and regularly rebalancing to ensure that investments are not disproportionately favoring certain companies or industries can protect from a lot of downside risk.

The best way to ensure that a portfolio is properly diversified is to create a target allocation of investment dollars and regularly review the portfolio as stock prices change to ensure that your allocations remain within the set targets.

A good rule of thumb is the 5% rule. This states that no single security should take up more than 5% of a stock portfolio. This allows investors to take a significant stake in companies they believe in but also limits the risk to the overall portfolio should that investment turn out to be a poor one.

There is No Magic Wand

If only learning how to build a stock portfolio was simple and easy. It is hard work and take ongoing attention to create and manage a stock portfolio that is designed to deliver great results.

However, the hard work may pay off with investment performance that outpaces many of the standard offerings retail investors flock to.

Do you have questions or concerns about how to build a stock portfolio? Contact Linden Thomas and Company today.

Linden Thomas & Company

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