How to Construct a Stock Portfolio

If you want to own a portfolio of individual stocks, you must first set some ground rules, otherwise you run the risk of jumping at every buy list or stock pick that comes your way, in which case you might as well buy an index fund because there are literally thousands of "buys" and "strong buys" out there.

Why Do You Want to Own Individual Stocks?

People own equities for one reason only: to make money. Picking individual stocks is riskier than owning an index fund so your aim must be to outperform the index.

Some people like the excitement of trading or the greater control over what to buy or sell and when, but those are not enough to justify the risk and effort.

Specialize

The market is too big for anyone to be equally good at everything. If you decide to diversify your stock portfolio by owning a growth stock, a value stock, a utility, a small cap and so on, your portfolio will be mediocre because you will not have the expertise to pick any of those positions intelligently. Instead, select an area you feel comfortable with and specialize in it. There will be enough diversification within. For example, you could trade large caps or small caps, growth or value, breakouts or biotechs.

Stay Within Your Comfort Zone

You may be attracted by fast profits in small caps but not have what it takes to trade them profitably either because you can't watch them throughout the day or because are uncomfortable with wild fluctuations. There is nothing more frustrating than losing money in a rising stock by buying and selling at the wrong times. On the other hand, you may be comfortable buying and holding slower moving larger caps because you can leave them alone while tending to other things.

Define Your Selection Criteria

Once you've decided what to specialize in, develop selection criteria that best apply to that group. For example, you can't use the same criteria to select biotechs and large caps. There are literally hundreds of selection criteria but no stock can possibly meet them all. In fact, the more criteria you use, the more likely you are to eliminate a big winner because no stock is perfect. The goal is to have as few vital criteria as possible to create a short cut to the best buy candidates.

How Many Stocks Should You Own?

There are no hard-wired rules. Obviously, one stock is too risky, 40 is too many. Some suggest using a set number, say 5 or 10, and if a 6^th or an 11^th candidate comes along, selling the worst performing stock to free up funds for the new candidate. I don't like this approach. People usually rush to buy their first 5 or 10 stocks as soon as they can, regardless of what the market is doing, but returns are never linear: in a good market, there may be 20 or even 100 good stocks worth owning, in a not-so-good one, there may be just one or two. By sticking to a set number, you will be limiting your choices in a good market and stuffing your portfolio with mediocre stocks in a not-so-good one.

What if all 10 picks look good and you pass up on an 11^th that goes on to become a tenbagger? Or you ditch one of your ten to make space for a newcomer that turns out to be a dog while the one you sold takes off?

Let the market decide how many stocks you own by limiting the dollar amount you put into any one. This way, you will be fully invested (and possibly even on margin) in a good market and largely in cash in a not-so-good one, provided you don't compromise on your selection criteria.

Have Sound Sell Rules

Buying a stock is only half the job. It is equally important to know when to sell. There are 3 reasons to sell: cut a loss, free up cash and lock in a profit. You must have rules for each one. It can be as simple as placing stops at the right levels.

I am not a big fan of taking profits at some magic number, say 20 or 30%, because how would you get a double if you cut your profits short? Some stocks may only go up 10 or 20% while others may double or triple; you need all the gains you can get to offset the inevitable losses.