To achieve your targeted allocation to stocks, you can invest in mutual funds, exchange traded funds and individual equities. Logic and research both highlight the efficacy of low cost index funds. You could put your entire equity allocation into a low-cost no-load index equity mutual fund or ETF and be done – and done well – with your stock decision making.
But other factors may lead you to do otherwise. Best practices specific to each vehicle are presented separately. The comments on diversification and capitalization apply to all.
Diversify overall
Never invest more than 5% of your portfolio in any single firm. If you hold mutual funds or ETFs exclusively, you are naturally diversified. You could put 95% of your assets in a fund and 5% into a specific stock and still be considered well diversified. If you only own individual stocks, you should have at least 20 of them. More would be better. You do not want your wealth significantly damaged through the poor performance of any single firm.
Diversify in detail
Even if you own funds or more than 20 stocks, you still could be susceptible to the unique risk of a sector or region. Familiarity or preference for a particular attribute such as dividend yield could lead you to concentrate assets imprudently.
Regarding industry exposure, Standard and Poor’s divides companies into ten major groupings: consumer discretionary, consumer staples, energy, finance, health care, industrial, information technology, materials, telecommunications and utilities. Broad index funds will own all of these. If you invest in sector funds or individual stocks, spread out. If you invest abroad, you might want to keep exposure to any individual country below 20%.
Consider large-cap firms your core
A firm’s capitalization is its market value, which is equal to the price of its stock times the number of shares outstanding. To guide investor expectations, companies are divided into capitalization categories. Though additional distinctions such as “mega” and “micro” get used, for the most part we invest in a universe of large-, mid- and small-cap firms.
The dividing lines can be blurry, and they go up over time as market values rise. As of this edition, a reasonable grouping would define large-cap firms as those with a market value above $10 billion, small-cap as firms valued under $2 billion, and mid-cap firms in between.
Large-cap corporations are huge. Most have been around for quite some time. Since you invest for the long haul, it can be of great comfort to know a firm has been and probably will be around for decades.
Small- and mid-cap stocks present potentially higher returns but greater volatility. Many of these firms fail, though others grow dramatically. Given their increased uncertainty, keep your exposure to each of these lower than your exposure to large-cap firms.
Stock mutual funds
Consider index funds first – perhaps only
Possibly the most efficient and profitable means to populate your stock allocation is utilizing index funds. Indexes have outpaced 90% of managed mutual funds in spans of 20 years or more.
The simplest investment is to put all of your equity money in just a few, maybe just one, broad index fund. Instead, you can get more involved with indexed exposure to specific sectors or countries. If you are tempted to invest in a fund not of the low-cost no-load index variety, avoid the pitfalls highlighted in our consumerist blog.
Minimize expenses
Research has identified the expense ratio as the single most influential factor determining relative performance between similarly invested mutual funds. One study conducted by a mutual fund rating firm found expenses to be even more predictive than the firm’s own rating system. Whether you use index or managed funds, going with the least costly choices in any investment category should serve you well.
Related, rule out all funds and fund platforms that charge or entail sales commissions.
Take size into account
For index funds, bigger is better. It is easier for a fund to match the contents of an index and smoothly handle shareholder transactions with a larger asset pool.
For managed money, bigger is not better. As you seek the benefits – real or perceived – of a specific stock picking team, you want their decisions to be effective. When a fund grows, the inclusion of an increasing number of securities causes its properties to progressively simulate an index, minus expenses.
Stock exchange traded funds
Consider index ETFs only
As discussed in our related post, managed mutual funds historically provide inferior returns versus index funds. This underperformance occurs despite perfect knowledge of each day’s net cash flow; mutual fund shares transact only after the market closes. ETF shares transact during market hours. Net cash flows are unknown until each instant investors buy and sell the ETF shares. With unknown cash flow and trading needs, a managed ETF is not likely to do as well as a managed mutual fund. Since the latter do not do well period, in the world of ETFs you are especially wise to stick with index choices.
Minimize expenses
Index ETFs are each intended to track the performance of a specific index. To the extent ETFs incur costs there will be some drag on performance. If two ETFs track the same index and have very different expense ratios, select the one with least expense.
Don’t overpay for the assets
While mutual fund shares transact at the precise net asset value (NAV) of the underlying securities, ETF shares transact at prices determined through the bid/ask process of the stock market. You do not want to overpay for anything.
So, when considering an ETF, navigate to the issuer’s site, look up the net asset value per share of the ETF under consideration and compare that NAV to the current market price. If the NAV is at or above the purchase price, you should feel comfortable moving forward. If the NAV is more than a few percentage points less than the price, find a more fairly priced ETF with the same exposure. If none exist, seek a mutual fund tracking the same index.
When all else is the same, favor larger funds
If you need to decide between two ETFs with the same target index, similar expense ratios and dramatically different sizes, choose the larger one. First, a larger asset pool makes it easier to emulate the contents of an index. Second, the price of an ETF is established in the open market through the same ‘bid and ask’ process of stocks. Small ETFs are more apt to trade at higher spreads, rendering lower prices when selling or higher prices when buying.
Individual stocks
If you have enough money, and the gumption, to buy 20 or more stock positions, you can build your own portfolio. This is not recommended; research, liquidity, risk and other factors favor index funds. Still, you may want to pick some of your own stocks. Whatever the reasons, the admonitions below are precautions intended to limit your downside risk and not advice to seek or buy any particular equity.
Don’t try to win the lottery
It is hard to find big winners. Many revolutionary products are brought out by private firms. If something of material importance is on the horizon for a public company, insiders and analysts researching the firm will discover it long before you. By the time you can buy into something new and exciting, the price probably already reached a level at which insiders would rather sell. If a broker is presenting an idea to you, you can be sure there’s a reason his firm is not simply keeping it for themselves.
Don’t ignore the numbers
When you buy a stock, you are buying future earnings. You are not buying cars, movies, airplanes, banks or really cool websites. Through ownership of a security, you have rights to a portion of future earnings, however and wherever those earnings are generated. If you pay a lot for a given level of expected earnings, you will probably not fare as well as you would have if you paid less for the same expected level. A low PE (price to earnings) ratio is good. A low PEG (price to earnings to growth) ratio is better. There are a host of metrics you can consider and helpful websites you can visit. If you are picking stocks in lieu of index funds, you should know why. Keep the numbers in your favor.
Ignore ads and cold calls
If someone you never met had an extremely profitable method to pick stocks, he or she would not tell you about it. Even if such a system did exist, it couldn’t last. Given the natural effects of supply and demand, if a large group of people used the same system, as they buy and sell the same securities prices would rapidly adjust to wipe out the system’s benefits. Never buy any security based on a tip or sales pitch, especially if it comes from someone you do not know.