Saturday, May 12, 2012

Building A Portfolio

In investing there is a saying "Never put all the eggs in one basket" and encourages diversification to reduce non-systemic risk in the stock markets.  By doing so, one need a portfolio in investment and holding numerous of investment entities.  I use entities rather than stocks as with the introduction of retail bonds, retail investors no longer restrict to just buying stocks in investment.  Bonds used to be for institutions and rich investors due to their huge capital involved but with companies starting to issue retail bond, retail investors now can have a pie of it.

How many investment entities should I put in my portfolio to achieve diversification ? Well for a very typical standard, one need to hold average 30 investment entities in order to achieve the best effect of diversification but with 30 investment entities you can estimate the huge amount of capital needed.  Normally those are what the funds with their million of dollar are doing with their portfolio.  As for normal retail investors, really depend on how much capital you have for investment.  The smaller number of investment entities you have in the portfolio without any doubt will provide lesser diversification ( note not totally no diversification !!! ).  Before going on suggesting how to build a portfolio, investors should have some knowledge of classification of investment entities as that will help to shape investor's risk appetite and how to build a portfolio that suit his/her own risk.  Do also note that below is my personal classification and not any industry standard but it is simple and suit normal retail investors well.

Income Investment Entity
As the name "Income" suggested, holding such an investment entity whose main objective is to generate constant income in the form of dividend or bond coupon payment annually.  These type of entity is very much suitable for retired personal who want a constant stream of income while staying vested.  Normally, entities classify under this category are Real Estate Investment Trust (REIT), Defensive Stocks and Bonds.  In Singapore according to law, REIT companies are supposed to payout 90% of their earning to unitholders in the form of distribution (dividend) in order to have tax exemption on their earning and with that, this has made REITs typically having a dividend yield higher than average market yield. A scan through all the REITs listed in SGX, those dividend yields span from at the moment 4.5% to as high as 10% and with Singapore having now an inflation of 4%-6% and not to forget GST of 7%, bank saving interest rate the best around 3%, investing in REITs is no doubt a better hedge against inflation and combat the low bank saving interest rate.  Defensive stocks as the name suggested are those companies in which their businesses are resilient even if economic situation enters recession scenario.  Businesses with that nature in Singapore are Telecommunication, Health care, Land Transportation, Utilities (water, gas and electricity), Military Defence, Consumer Services/Consumption (Newspaper, Postal services, Food & Beverage ).  These stocks normally do not pay high dividend yield as compared with REITs but they provide constant dividend payout annually regardless of economic situation (dividend payout is sustainable even in recession scenario ) and on top of that they offer slightly better capital appreciation in term of stock prices as compared with REITs.  The last entity in this category is Bond.  Of the 3, bond is supposed to be a safer investment entity as compared with the other two.  Should a company goes burst, bond holders have higher priority than ordinary shareholders in the line of creditors and bond holders also have the higher priority of getting dividend payout when the company announce dividend payout.  To offset the so-called safer nature, bond interest rate ( pay in the form of coupon ) is typically lower than the other 2.  Furthermore, bond has maturity date while the other 2 an investors can hold as long as he/she likes.  Also some bonds are callable that is the issuing company can redeem or purchase back the bonds from bond holders within maturity period by paying back bond holders 100% of the physical amount invested.  All 3 entities provide constant payout of dividend/interest rate by the company and hence the classification of "Income Investment Entity" and very suitable for low risk investors.

Growth-cum-Income Investment Entity
This category of entity, mostly stock, as the name suggested enable shareholders to enjoy a constant income stream of dividend payout (divided yield much lesser as compared with pure Income Investment Entity) and at the same time share price appreciation when the company grows in its business.  Do note that such companies do not have a so-called recession proof business and in fact most of their businesses are rather cyclical in nature.  When economic situation is bad, the company revenue will take a hit and when economy is rosy, they enjoy the ride up due to growth in businesses.  To offset the cyclical in their businesses, these companies typically have strong cash flow which allow them to constantly payout dividend to shareholders ( amount might subject to lesser when economy situation is bad ).  Companies under this category in Singapore are Banks, Property developers (with strong cash flow), Offshore/Marine companies (with strong cash flow), Aviation companies (with strong cash flow), Commodity companies (with strong cash flow) and Stock Exchange company.  Screening through those companies listed in SGX, one can find those blue chips mostly fall into this category.  This category well suited for investors with medium risk appetite.

Growth Investment Entity
As the name suggested, the management of these companies typically very much focus in growing the company.  They normally conserve the cash reserve as working capital and giving out dividend to shareholders probably is not their higher priority.  Should they decide to give out dividend, the amount will be just a token amount and that will be an additional bonus to shareholders.  To offset that, they have strong share price appreciation and even outperform the blue chips or leader in their respective sector should be economy condition becomes very rosy.  However, when economic situation turns sour or in the recession case, the stock price without any doubt will drop more than anybody.  Stocks under this category listed in SGX are mostly the laggard stocks in Offshore/Marine, Property developers and Commodity companies.  These companies have the strong fundamental but do not have the strong cash flow position as compared with the blue chips in general.  This type of stocks is very well suited for investors with high risk in which they have higher tolerant of risk appetite to exchange for the strong capital appreciation.

Regardless of "Income", "Growth-cum-Income" or "Growth" Investment Entity, all have downside risk and investors should bare in mind that.  The worst scenario is for the company to belly up and investors lost all the investment capital.

Now, back to building portfolio.  I shall break into 3 distinct category namely, Defensive, Balanced and Offensive and that is in correlation with the 3 distinct risk types, Low Risk, Medium Risk and High Risk.  In each of the category, the composition of the 3 investment entities will be allocated accordingly. 

Defensive Portfolio
As the name suggested, this is targeted towards investors with Low Risk appetite.  With low risk that will also translate to expectation of low gain too.  For this group of investors,  they could only target the Income Investment Entity namely REITs, Defensive Stocks and Bonds.  Also note that within REITs and Defensive stocks themselves, they can be further divided into different sectors ( based on their businesses eg Retail, Healthcare, Commercial, Hospitality, Consumer, Utilities, etc ) and to pick 1 from each of this sector can provide certain degree of diversification.  Example to hold a 7 stocks ( typically the case if one has investment capital of at least $50k ), the investor can choose one from each of the sector like 1xHealthcare, 1xCommercial, 1xUtilities, 1xBond, 1xIndustrial, 1xRetail and 1xConsumer.

Balanced Portfolio
This category is targeted towards investors with Medium Risk appetite.  They want certain assurance of constant income from investment and at the same time wanting that extra bit of capital gain from their investment.  Do note that with that increase in risk level, they ought to have a higher tolerance for the downside as compared with investors with Low Risk appetite.  For this group of investors, 3 possible combinations are as followed.

1. Income + Growth-cum-Income Investment Entities
50% of the investment capital targeting on Income Investment Entity and the remaining 50% on Growth-cum-Income Investment Entities.  As again, pick 1 from each of the sector within the Investment Entity to achieve diversification.

2. Growth-cum-Income Investment Entity
Purely 100% on stocks that are categorized in the Growth-cum-Income Investment Entity.  Since these stocks can provide dividend which forms the assurance of constant income component in the portfolio and the higher capital gain from these stocks ( as compared with Income Investment Entity ) will contribute to that extra bit of capital gain component in the portfolio.  Again, pick 1 stock from each of the sector within the Investment Entity to achieve diversification.

3. Income + Growth-cum-Income + Growth Investment Entities
For this case, all 3 investment entities are involved with composition as 50% of the investment capital in Income Investment Entity, 40% of it in Growth-cum-Income Investment Entity and 10% on Growth Investment Entity.  Again pick 1 from each sector within that Investment Entity to provide diversification.  For the case of 10% into Growth Investment Entity, probably one could only choose 1 stock from that category and advise is to select the company in which you know the business well.

Offensive Portfolio
This category is very much aggressive and well suited for investors with High Risk appetite.  These investors can do away without any form of constant income stream ( dividend ) and target only pure capital gain from their investment.  As such, they ought to have high risk tolerance as the stock prices can go for a wild swing based on economy situation.  For this group of investors, 2 possible combinations are as followed.

1. Growth-cum-Income + Growth Investment Entities
50% of the investment capital on Growth-cum-Income Investment Entity and the remaining 50% on Growth Investment Entity.  Picking 1 stock from each sector to diversify.

2. Growth Investment Entity
Purely 100% all on Growth Investment Entity, this perhaps is for investors with the highest risk appetite.  Again to have diversification, pick 1 from each sector.

What provided above is a rough guide for investors with that distinct level of risk appetite and should an investor has a risk appetite that falls in between the distinct level, adjustment of the composition of the entity will have to make accordingly. 

Investment is something personal and only the investors themselves know of their own risk and rewards levels. From a retail investor point of view due to limited investment capital, a rule of thumb from my investment experience is that holding between 5 to 10 stocks in a portfolio would be just nice so as not to over stretch and being under invest. 

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