A Short Guide to the World of Financial Investments. Part Four
Building an Investment Portfolio: How to Achieve the American Dream, What You Need to Know to Avoid Being Downgraded from Billionaires to “Mere” Millionaires, and the ABBA Song as a Reflection of Our Life
What It Is, Why You Should Do It, and Where to Start
In the third part of this short guide, we found out how the fundamental value of various assets is determined. We also identified the principles you should follow when determining the value of a stock in the long and short term.
One of the world’s most famous investors and speculators George Soros was claimed to have said that if you want to become a billionaire your capital should grow by at least 20% annually. However, reaching this growth rate will require knowledge, experience, networking skills, resources, and the psychological ability to use almost all methods that are not prohibited by law, even if some of them may seem questionable from a moral point of view. The “American Dream” requires sacrifice the way beauty does. And it may require not only your personal sacrifice. The way to your “greatness” may have an unpredictable impact on other people’s lives too.
It is important to remember that Soros began his career in finance at the age of 24 and worked for many years as a trader and analyst before starting his own investment fund. And he did it only when he had reached the age of 39, having invested his personal 250 thousand dollars. He became a billionaire only at the age of 62 back in 1992 by bringing down the British pound exchange rate and by inflicting serious damage to the reputation of both the British government and the Bank of England in the process.
There are so many books and publications covering the “how to become a millionaire” topic that some bestsellers, indeed, helped some of their authors to become millionaires. That is why, in this part, we would better focus on how to build an investment portfolio and implement investment strategies that would help billionaires avoid being downgraded to “mere” millionaires.
When building your investment portfolio, you can adhere to the simple principle of 60/30/10 (see Picture 4.1 below).
This means that 60% of your investments should form the “core” of the portfolio where the “core” consists of assets whose value is related to the current structure of the economy. In the context of financial markets, for example, these may be securities issued by stable, traditional companies that form the backbone of today’s economy. The selection of shares for the “core” should be based on the fundamental principles of asset valuation discussed in Part Three.
30% of the portfolio can be labeled as the “future core”. It may consist of securities issued by companies that are associated with “promising” industries with the prospect to become the “backbone” of the economy in the near future. This means that goods and services produced by such companies may become “traditional” within the next 5 years. The selection of stocks for this part of the portfolio is based on both fundamental and psychological factors. In order to correctly identify interesting and viable investment options you should maintain a realistic attitude, while not forgetting to use your imagination. Classic examples are mobile communications and the Internet. In the 1990s these were “promising” areas. Now they have become essential services. There is no doubt that the process of identifying “promising” areas is not easy and requires self-study or consultation with investment professionals, but it is extremely important in order to ensure your future financial well-being.
10% can be invested in speculative assets: “cheap” shares of problematic companies, shares of companies whose products one is very passionate about, trendy and fashionable stocks. When selecting stocks for this part of the portfolio, we rely on psychological factors as well as on various methods of technical analysis.
Finally, observing the principle of diversification — “do not put all your eggs in one basket”, “do not transport all your goods on one ship”, etc. — was, is and will be the basis of a successful investment process.
Thus, when building a stock portfolio, we can apply certain rules to each of the three subportfolios we discussed earlier (see Picture 4.2 below). These rules imply that
1) when assembling the «core» of the portfolio — these are the stocks of stable, traditional companies — we rely on fundamental factors. This implies that we buy a stock when its market value is lower than its fundamental or intrinsic value derived from one of the fundamental models that were discussed in Part Three.
2) when assembling the «future core» of the portfolio — these are the stocks of “promising” companies — we must be both realistic and imaginative. Being realistic means that we rely on the same fundamental factors that we use when assembling the «core» subportfolio. While being imaginative implies that we have to buy the stocks of the companies whose profit growth rates may exceed the average market profit growth rate over the next five years.
3) when assembling the “speculative portion” of the portfolio, we should strive to buy the stocks of the companies that may experience rapid and strong price gains for various reasons. That is why, in the context of speculation, we should buy the stocks of the companies whose profit growth rates may, for example, exceed the average market growth rate over the next five years. Or we should buy “charismatic” stocks that attract investors’ attentions. The best scenario is to purchase the stocks of the companies that meet both criteria. Technical analysis methods are used to make investment decisions more quickly in a highly volatile stock price environment.
Now we can summarize major principles when constructing a stock portfolio (see Picture 4.3 below):
1) a higher potential return on investments is always associated with a higher level of risk. This certainly does not apply to situations involving insider trading, namely, the use of non-public information that is not available to other investors. We may also encounter situations when some stock mispricing is involved. Most successful, traditional investors are doing just that: looking for unfairly undervalued stocks.
2) the longer the investment horizon, the lower the level of risk associated with this investment. This implies that fundamental factors will play the most important role in the long term, while in the short term the stock price may deviate significantly from its fundamental or intrinsic value.
3) to reduce the level of risk involved one may apply an “averaging” technique. This means that your portfolio should be assembled in a gradual manner by making regular incremental purchases of stocks, say, once a month, once a quarter or once every six months. Building your portfolio in this way will help you avoid any catastrophic market events, thus smoothing out its “average” value.
4) the better a company’s general financial position, the lower the degree of risk involved. This principle is obvious.
5) from a fundamental point of view, one should buy the stocks of the companies whose market value is lower than its fundamental or intrinsic value.
6) companies are defined as “promising” if their profit growth rates may exceed the average market or industry growth rate over the next five years.
7) companies are defined as “charismatic” if they excessively attract investors’ attention. The stocks of these companies are bought to exploit certain human psychological traits.
Finally, we can formulate certain rules — let’s call them investment commandments for non-professionals — to be applied in practical situations (see Picture 4.4 and Picture 4.5 below):
1. Sell losing positions quickly. Do not sell winning positions too early. Minimize positions showing poor price performance or sell them during market bounces as even dead cats bounce back if they fall from a great height (I respect cats!). There is a well-known saying that for many investors their long-term investment portfolio is based on failed short-term speculative trades. Try to avoid these situations.
2. Do not invest without an investment objective and goal, thus exposing yourself to unreasonable financial risks. Set the metrics that you strive to achieve. Regardless of whether these are long-term investments or speculative trades, there should be a plan of action in case of success or failure.
3. Emotional biases should be avoided when making investment decisions. This implies that the best approach is to open and close investment positions based on certain rules defined before making a trade.
4. Follow the trend. The overall performance of your investment portfolio will be largely determined by the dominant market trend. For long-term investments “the trend is your friend”. The most successful long-term investments tend to have a moderate but consistent growth rate.
5. Never allow a good profit to turn into a loss. If some stock has recorded rapid price gains, it would be prudent to take some profit on it. There is a saying that “you can’t be wrong in taking profits”. This primarily applies to speculative trades.
6. Your chances of success are significantly improved when fundamental analysis is supported by technical analysis. If these two approaches agree, you will join both those traditional investors who make their investment decisions based on some fundamental factors, and the “technicians” who follow the rules of technical analysis. This will significantly expand the pool of potential investors, thus contributing to the strength of an underlying price trend.
7. Avoid adding to losing positions. This is called “averaging down” and it is rarely effective. Basically, this implies that it is better to stick to the principle of diversification and avoid “putting all your eggs in one basket”.
8. During a bull market, remain largely invested in risk assets. During a bear market, increase the size of your cash balances. There are many definitions of bull, or rising, and bear, or falling, markets. In general, bull markets usually occur when the economy is strengthening or when it is already strong. They tend to happen in line with strong gross domestic product (GDP) growth rates and declining unemployment rates. Bull markets are also often accompanied by a rise in corporate profits. Investor confidence will also tend to climb throughout a bull market period. The overall demand for stocks will be positive, along with the overall tone of the market. In addition, there will be a general increase in the amount of initial public offering (IPO) activity during bull markets. Bear markets occur when stock prices decline by more than 20% after record highs. This is usually accompanied by a drop in investor sentiment and deteriorating prospects for the economy. The nature of bear markets can be both cyclical and longer-term. Cyclical bear markets may experience a decline for several weeks or a couple of months, while long-term bear markets may fall for several years or even decades. “Short selling”, put options and inverse exchange-traded funds (ETFs) are some of the strategies and instruments investors can use in trying to make money during a bear market as prices fall.
9. If markets deviate significantly from long-term trends, trade against the “crowd” by opening positions in the direction opposite to the opinion of the majority of investors. Mathematically speaking, when a movement in the price of some stock exceeds 2 to 3 standard deviations based on its historical average price dynamics, there is a good chance (95% to 99%) that it may experience a pullback or a price correction. Please read my article Eurovision, King Dollar, Bitcoin, and Other Victims of Popularity covering this topic.
10. Practice what you preach and do what you believe. This implies that your investment rules must be practical and actionable. If you formulate some “buy” and “sell” rules, follow them in real life too.
11. Manage your investment portfolio so that there are at least two or three profitable trades for each unprofitable one. In the long term, consistency is the key to success. If you cannot achieve this rate of success, you need to reassess your investment strategy.
12. Focus on controlling your risk and volatility rather than your profits. There is a financial market saying that “new” traders, in terms of experience rather than age, think about profits, while “old” traders, in terms of experience rather than age, think about losses. The underlying logic of that saying is rooted in the fact that financial markets do not forgive strategic mistakes. And, most often, they do not allow you to restart the “game” again.
And we should also remember that capital is not just about finance. The principle of diversification should be extended to other areas of your life. Capital is usually understood as financial resources. But the physical and psychological health of an individual is no less important in ensuring his or her well-being. This component can be called his or her “biological” capital. While the presence of qualities that allow you to function normally in a social environment — education, experience, sociability, and communication skills — allow an individual to build his or her “social” capital. All these three types of capital interact with each other. The greater your “biological” and “social “ capital, the greater the risk you can afford in relation to financial investments. And conversely, the single-minded pursuit of wealth at the expense of your health and social skills is unlikely to be sustainable over the longer term.
That is why when a line from the popular ABBA hit, “And win a fortune in a game, my life will never be the same,” comes to your mind again (see Picture 4.6 below), remember that in these lyrics there is more irony than reality.
To be continued…
