Three golden rules to share market success

I was recently talking with an auditor of self-managed super funds who claimed that more than 90% of the funds he audited were either running at a loss or achieving at best a 5% return.

These types of figures don’t surprise me and can be attributed to investors’ lack of knowledge in how to select stocks and manage a portfolio. Unfortunately, this is a common problem for many investors who are attempting to invest directly in the share market.

(If you would like to know more on setting up a successful self-managed super fund portfolio, I recently recorded three podcasts where I talk you through the process in much more detail. To listen to part one, click here).

In my experience what investors need is a practical framework that will allow them to select stocks in their portfolio that have a higher chance of ensuring they are consistently profitable. Therefore, my aim in writing this article is to provide you with a set of guidelines that will enable you to construct a portfolio that will consistently perform year in year out.

Whenever I am presenting to an audience, I always ask how attendees select stocks and I must admit the answers always astound me. The most common responses are newspaper, magazine and stock broker recommendations. Others include tips from friends, family, taxi drivers or the fact that they liked the name of the company or they used the company’s products and services.

Let me say up front, this is not the way to select stocks if you want to consistently profit; these methods are both inconsistent and ineffective. What I have discovered is that most people spend more time planning for a holiday than they do on building a consistently profitable portfolio.

Think about it this way. If you were to invest $500,000 in an investment property right now how much time would you spend learning and researching the type of area and property you are to invest in to be confident you get a good return? Your answer, no doubt, is probably lots of time. Now let’s assume you wanted to invest $500,000 in one stock (although not advisable), how much time would you invest in learning and researching not only how to invest in the share market, but how to select the right shares so that you invest your money safely and get a good return? Again, the answer would be a considerable amount of time.

The amount we invest, however, tends to change our perception of the risk we are taking and the research required to manage that risk. Usually this is because it is much easier to swallow a $1000 mistake than if you make a mistake with $500,000. But let me assure you the process you take to invest $500,000 or $1000 should be exactly the same, as they both represent the same amount of risk.

What follows are the three golden rules you need to consider when building a portfolio to reduce your risk and increase your profits.

1. Take your time to do the research

Irrespective of the amount of money you have to invest, you should always take the same amount of time researching your options to ensure you are protecting your capital on each and every occasion.

2. You should always aim to have between five and 12 stocks in your portfolio when investing in the share market

The trick is to not have lots of stocks with small amounts invested in each. Instead, you only require a small number of the right stocks with larger amounts invested in each. This actually lessens your risk and increases your returns because:

Smaller portfolios are easier to manage and represent lower risk. The more stocks you have in your portfolio the more work you need to do to manage your risk level.

It is far easier to select a smaller number of stocks that are rising in price. Therefore, the result is increased returns.

You will have less transaction costs in buying and selling stocks simply because a smaller portfolio will have fewer transactions.

3. Never invest more than 20% of your total capital in any one stock

If you invest in the share market you need to accept that some stocks will fall in value. However, this rule will help reduce your exposure to risk, while allowing you to achieve good returns simply because you are minimising the amount of capital you could lose at any one time.

For example, if you invested $100,000 in five different stocks, you would be investing $20,000 in each stock or 20% of your total capital. If at the end of your first year one of the stocks dropped by 50%, you would lose $10,000 of your initial capital. But if the other four stocks had risen in value by 10%, then you would have made $8,000. Therefore, your total loss would be $2,000 or only 2% of your initial capital. In effect, you have minimised your exposure to risk by spreading your capital across a number of stocks.