Investing in stocks is arguably the most exciting and crucial aspect of building your investment portfolio. Stocks provide the capital growth that drives the value of your portfolio upwards over the long term. However, picking the correct types of stock investments is often an overwhelming and time consuming process. On top of the roughly 6,000 stocks listed on American stock exchanges (with more coming everyday in the red-hot IPO market), there are now thousands of ETFs and funds covering countless different investment strategies to choose from. How do you whittle this universe down to pick the right investments?
Here are Winthrop’s top 4 tips for investing in a portfolio of stocks:
1. Pay Attention to sectors….
One of the most important factors in how your portfolio performs is it’s breakdown between the different sectors of the economy. Currently there are eleven broad sectors in the stock market including technology, healthcare, financials, etc. If you put your portfolio into a pie chart based on sector breakdown, we could glean how your portfolio has performed within a few percentage points without knowing a single stock that you own. The sector breakdown of an investment portfolio is responsible for the vast majority of your returns while the specific stocks that are owned explain the rest. This is especially true in recent years with the proliferation of funds and ETFs that track specific industries and tend to clump the performance of similar stocks together. So as you begin, think of the eleven sectors as your first step in shrinking the universe of investments to choose from.
2. ….And industries
Equity sectors are further broken down into many different industries. For instance, within the technology sector there are numerous categories like software, IT services, and semiconductors. These industries are also crucially important in building a diversified stock portfolio. We often see new clients with portfolios that seem to be diversified on a sector level but are overweighted in specific industries. A common occurrence is a portfolio with 3 or 4 financial stocks that are all banks; what about insurance, capital markets, or asset management? Similarly, we often see biotech/drug stocks as the only representation of healthcare in portfolios when there are over a dozen different industries within that sector.
It doesn’t matter whether you start your stock picking search at the industry or sector level. You don’t have to buy every sector and industry either. What really matters is that you are comfortable investing in the areas you choose and have a solid thesis for why you favor them. If you are building your portfolio yourself, I would recommend using an online stock screener to search for stocks in the sectors and industries you like.
3. Qualitative before quantitative research
The most successful investors screen for stocks based on fundamental metrics (quantitative) while also looking for certain characteristics in a company (qualitative). Quantitative metrics such as Price/Earnings and Price/Sales ratios are popular for gauging the relative valuation of companies. However, qualitative characteristics should come first in your research; does the company have a good leadership team? A solid growth market for the future? How does their product compare to competitors’?
In recent years, many of the best performing stocks have seemed overvalued based on quantitative metrics like P/E or P/S; think of Tesla, Apple, or Peloton. These companies all share certain qualitative characteristics: they have strong leaders, are dominant in their industries and have superior technology to address fast growing markets. Because these companies are uniquely positioned, investors have been willing to pay higher prices for these stocks. Using quantitative research can then help you avoid bubbles and stocks that don’t deserve ultra-high valuations. Make sure a company is growing sales consistently and has a clear path to profit if not there already. Additionally, look at free-cash flow and debt levels to screen out stocks that are on unstable footing.
4. Take advantage of low-cost ETFs
ETF stands for Exchange Traded Fund. ETFs, like mutual funds, hold baskets of stocks that you can buy in a single share. They differ from mutual funds in that ETFs trade all day on an exchange like a stock does, while mutual funds are only priced once a day after the market closes. ETFs have exploded in popularity in recent years and there are now funds tracking almost every sector, industry, or theme you can imagine.
ETFs are most useful for investing in areas that should be part of your portfolio but are difficult to buy individual stocks in. For example, international stocks, small-cap stocks, emerging markets, and commodities make it tough to build your own diversified basket of stocks. Using a low cost ETF allows you access to these markets without having to research dozens or hundreds of stocks yourself. In most cases, investors will have better outcomes buying an ETF than buying your own investments. ETFs also have tax advantages and offer different ways to access these markets (like controlling for currency swings in international markets and offering access to futures markets for investing in commodities). Keep it simple in these asset classes by using ETFs.
Here at Winthrop, we use these four strategies and more as part of a meticulous portfolio building process. Contact us today for a complementary Portfolio X-Ray and a first draft of our financial goal planning process.
Written by Ryan Carney