Every market correction brings a lot of investment opportunity where lot of quality businesses are available at attractive price. Times like these are best suited for investors looking to build a portfolio. In this post, we are going to give you a step by step guide on how to build a profitable portfolio?
A portfolio is a set of financial asset classes, designed in such a way as to minimize risk and maximize potential gain and help you in achieving your financial goals.
Since there is no such thing as perfect performance by perfect timing or picking only winners, it becomes important to build a solid portfolio that allows you to succeed and avoid the stress and worry about the daily volatility of the market.
In other words, a well built portfolio not just creates wealth for you, but also provides peace of mind while doing so.
Without wasting much time, let’s now delve into step by step process on how to build a profitable portfolio, that makes money and not worries.
Invest With a Purpose
“If you don’t know where you’re going, you will miss the destination every time” -Yogi Berra
The first step on how to build a profitable portfolio is to understand your purpose and goal of investing.
Ask yourself, Why do I want to invest? Your purpose could be anything personal such as educating your kids, planning a vacation, buying a house etc.
Having a clear goal in mind would not only help you understand your current financial standing, but will also help you figure out how far you have to go and what it will take to get there.
In my experience, I have encountered many people who set unclear and ambiguous goals. You need to understand the difference between goal and a wish.
Every financial goal must have a clear amount and time frame within which it must be achieved.
Saying ”I want to be rich” is a wish and not a goal, as it does not determine at what point you would start to feel rich.
On the other hand, saying ”I want to buy a house worth Rs, 10 crores in the next 30 years” is a goal as it clearly mentions the exact amount needed and the time frame within which it must be reached.
The second point on how to build a profitable portfolio is to be realistic about your risk appetite and expected returns, as every investment comes with an inherent risk.
Very few of us have a realistic understanding of risk appetite, which is mainly about how much risk you are willing to take in order to achieve that goal.
Let me give you a simple example. Suppose you reach your office in 30 minutes if you drive your car at a speed of 50 km/hr.
So, if you drive at twice the speed(that is 100 km/hr), you will reach office 15 minutes early. But will you risk driving a car at 100 km/hr to save 15 minutes off the clock?
The best way to assess your risk appetite is by analyzing the tradeoff between what you want to achieve and what you have to risk in order to get there.
If you can deal with the risk involved for the goal you want to achieve, fine, else you need to adjust your goal or the time frame.
Determine Asset Allocation
The second step on how to build a profitable portfolio is to determine the asset allocation.
Once you have clear idea of your goals and risk appetite, it’s time to pick investment products or asset classes based on your goals and risk profile.
Your asset allocation depends on a combination of two major factors. Your age, and your current financial standing.
Understanding these two factors is crucial for intelligent asset allocation as it helps you in determining your risk tolerance.
Your Age
Your age is a crucial factor in determining how much time you have to grow your portfolio.
An unmarried college graduate who’s just beginning his career will have different financial needs than a 55 year old, married person, expecting to pay for his child’s education.
It is always better to start investing early. Earlier you start investing, better it is as you have more time to grow your portfolio.
Also, having more time in your hands allows you to take higher risk. In case you make a mistake and lose money, you still have time to recover those losses.
Your Financial Standing
The second factor to consider is the financial standing of an individual, that is how much money you already have and how much you need to achieve your financial goal.
For example a young professional who has been living frugally, saving most of what he makes will have a stronger financial standing compared to a person who is few years away from retirement but has been spending most of what he has earned.
In such cases, the young professional can chose to be aggressive in his investment approach as he is backed by strong financial standing in case he suffers a loss.
On the other hand, the person, close to retirement cannot afford to take too much risk as he cannot afford to lose whatever he has left.
Based on the two above mentioned factors you need to understand your investment approach, whether you are a conservative investor or an aggressive one.
Conservative Vs Aggressive investor
Assessing your risk tolerance is an important step in our guide on how to build a profitable portfolio.
Generally, the more risk you can take, more aggressive your portfolio should be. An aggressive investor allocates larger percentage of his portfolio to high risk, high return stocks, which is usually mid and small cap stocks(small and mid caps are high growth stocks, but have high risk as they have huge volatility).
Conversely, a conservative investor’s portfolio would contain relatively safer, large cap stocks, or may even opt to invest in a completely different asset class such as high grade fixed income instruments.
So what should be your asset allocation based on risk appetite? Well, the numbers may vary from person to person, but I am going to give you few ballpark figures on percentage of assets allocated in various types of stocks.
A young aggressive investor can have higher exposure to mid and small cap stocks. Such investors should allocate anywhere between 10%-20% of his overall invested amount in small cap stocks and another 20%-30% midcap stocks. Rest of the 50%-60% should be invested in large cap stocks
It is important to mention here that you should never invest your entire amount in stocks, always keep 5%-10% of your total investment in cash or whenever the market presents a great opportunity where good stock are available at attractive valuations.
For example, if you are investing 10% of your total capital in small caps and 20% in mid caps, out of remaining 70%, you can invest 60% in large cap (or blue chip) stocks and keep remaining 10% as cash.
Similarly, if you are investing 20% of your capital in small caps and 30% in mid caps, out of the remaining 50%, you can invest 40% in large cap stocks and keep remaining 10% as cash.
A conservative investor on the other hand, should allocate majority of his capital in relatively safer, large cap or blue chip stocks, composing somewhere around 70%-80% of the total capital.
If you are still not comfortable holding stocks, you can always chose other asset classes such as fixed income instruments(fixed deposits, bonds etc.)
Remember, these are not hard and fast numbers carved on stone, you can always alter your percentage allocation based on how much risk you can afford to take, so do not shy away from playing with the numbers, sometimes a small change can show drastic improvement in results.
Portfolio Diversification
The third step in our guide on how to build a profitable portfolio is diversification of portfolio. Portfolio diversification is careful allocation of capital with main objective of de-risking your portfolio.
This may sound similar to asset allocation, but has some major difference. The main goal of asset allocation is to allocate your capital in such a way so as to maximize risk and minimize returns.
On the other hand, portfolio diversification is a continuous process and need frequent re-balancing based on changes in market condition and changing financial needs of an individual.
You can read a detailed post about portfolio diversification, its advantages and how to do it, from the link given below:
Portfolio Diversification: Advantages, Types, and How to do it?
Rebalancing Portfolio
The fourth step on How to build a profitable portfolio is to rebalance your portfolio. Since market movements can drastically change your portfolio weightage, it’s important to keep an eye on your weightage of assets in your portfolio and keep rebalancing once in a while.
Rebalancing portfolio is all about changing asset allocations in a timely manner to prevent your investment from overexposure to certain assets and potential risk of heavy losses.
Other factors that may require rebalancing your portfolio is change in your financial situation, risk tolerance, and future needs.
To re-balance your portfolio you need to determine which assets have overweighted and the ones that are underweight.
For example, if small cap stocks for more than 30% (or whatever percentage your are not comfortable with), while your asset risk tolerance suggests to keep it under 20%, it’s time to reduce your exposure to small caps by booking profits and re-allocating the proceeds in some other asset class.
An important point you should keep in mind while re-balancing portfolio is the tax implications. For example if a stock has performed extremely well in past few months and you are planning to book profit and reallocate the capital somewhere else, you may have to incur significant short term capital gains tax on it.
In such a case, it might be more beneficial to simply not contribute any fresh funds to that asset class while continuing to contribute to other asset classes. This will reduce your overall weightage in that asset class without any tax implication.
Maintain Discipline
Picking the right assets, diversifying portfolio is just one side of how to build a profitable portfolio.
Most investors lose money and give up on investing not because they have poor planning or stock picking skills but because they do not have the right discipline needed to become successful investor.
There are four major points you need to keep in mind while investing, which will help you in maintaining the right discipline and right mindset needed.
Think Quality over Quantity
The first point on our fifth step of how to build a profitable portfolio is to focus on picking few good quality stocks rather than loading your portfolio with too many low quality stocks that may not perform well.
Most investors chase “hot stocks” that has given extraordinary returns in the past, without paying attention to its underlying fundamentals and valuations, hoping that its past performance will continue in the future as well.
What they do not understand is that past performance is not a continue in the future, especially if the underlying fundamentals of the company tell a different story.
Note: If you want to understand how to perform fundamental analysis of any stock, you can read my “Complete Guide to Fundamental Analysis of Indian Stocks”
A “hot stock” may appear to offer exceptional returns in the short term, but if it isn’t supported by strong fundamentals, it may actually stumble out of the gate.
Having a portfolio of few, but good quality stocks with strong fundamentals and attractive valuations would fetch far better returns, compared to the ones that give exceptional returns in the short term but destroy your wealth in the long term.
Give it time to grow
Investing is a marathon, not a sprint. Investing is like planting a seed, you cannot expect to throw seeds on the ground and expect it to germinate the next day. You have to be patient.
Peter Lynch in one of his books “One up on Wall Street” said:
“A stock is not a lottery ticket, it has a business running behind it.”
When the business does well, earns more, and grows in value, it ultimately gets reflected in the price of the stock. But for that, you have to give the business time to grow.
So whenever you invest in stocks, maintain a long term view, and be patient with your investment, and over a period of time you will find your portfolio is making you richer each day.
Do not be obsessed by day to day volatility
Stock market is a voting machine in the short term but a weighing machine in the long term. What it means is, in the short term it is the sentiment of the market participants that determines the price of the stock, but in the long term it is the fundamentals, and financial performance of the company that determines its true value.
Every investor must understand that markets can remain volatile from day to day or even month to month, but over the long term volatility subsides and value drives the price of a stock.
The best way to deal with daily volatility is not to be obsessed with it, and maintain a long term view on your investments that delivers consistently positive returns over a period of time.
Stay focused on what you can control
Final point on our guide on how to build a profitable portfolio is to focus on the factors you can control.
There are many factors beyond one’s control that influence a stock’s price and there is no way you can control them or even do something about them.
You cannot control the market, the companies that you have invested in, you have no control on the political climate, crude oil, rising or falling currency exchange rates and so on.
Instead of being swayed away by the factors beyond your realm of your control, it’s better to stay focused to your investment strategy and stay committed to it.
Conclusion
Concluding the topic of how to build a profitable portfolio, all I can say is building a profitable portfolio is not a hack or a trick which can be implemented to make tons of money overnight, it’s like planting a seed, which takes time some efforts, and most importantly, patience and consistency in order to give fruitful results.
Rather than focusing on the short term gains, it’s always better to focus on long term wealth generating strategies, it is what some of the most successful investors in the world have done to create wealth for themselves. As Peter Lynch himself once said in his book Learn to Earn
“My best stocks have been third year, fourth year, fifth year I have owned them, it’s not the third week or fourth week, people want their money very rapidly, it simply does not happen”
A well diversified portfolio is the best bet for a consistent long term growth. It protects your investment from large declines, and changes in the economy over time.
So create a well diversified portfolio, make adjustments when necessary, and you will greatly increase your chances of long term financial success.
That was all in our guide on how to build a profitable portfolio, hope you find it knowledgeable and enjoyed it reading as much as I enjoyed it writing.