Maintain the Correct Portfolio Attitude

Physician's Money Digest, July 2005, Volume 12, Issue 10

The problem:

Some investment experts theorize that it's not dif-ficult to earn a good return in the stock market.What is difficult is hanging on to that return.Many investors fail to focus onthe long haul, taking far too many chances on quick,substantial gains.

However, while the chances to achieve those gainsare limited, the opportunities to goof up along the wayare endless. And every time you sell one stock and buyanother, you're opening the door to more mistakes. Inthe words of Warren Buffett, "the stock market isdesigned to redistribute money from the active to thepatient."So if you want to have a sound, goof-proofportfolio, you have to have patience. In addition topatience, it's also a good idea to maintain the followingkey principles when it comes to your portfolio:

•Focus on big companies. Why is bigger better?Large, blue chip companies are easy to follow. They'realso generally more stable than smaller companies. As aresult, they offer most individual investors the optimumtrade-off between risk and return.

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What percentage of your stockholdings should beblue chips? According to , a lot depends on yourappetite for risk. Generally speaking, the younger youare, the more you can afford to take risks because youhave a longer period of time to make up for unexpectedlosses. The thing to remember is that even large stocks instable industries can be volatile. For example, Procter &Gamble has experienced large losses within a 3-monthperiod. Therefore, carefully consider how much volatilityyou can handle.

•Variety is good. The second principle in developinga sound portfolio is to select companies from acrossthe spectrum, combining stocks that have a variety ofgrowth rates. That includes large growth stocks thatreceive almost all of their return from earnings gains, aswell as conservative dividend-paying stocks that yieldmore than 2.5%. Generally speaking, growth stocks performbest when the economy is speeding up. In comparison,conservative stocks do their best when businessconditions are slowing down. To allow for that variation,select a wide range of leading companies, fromgrowth to income.

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•Eight is enough. The article recommendsthat you purchase stocks in at least eight different industries.Different businesses respond differently to changesin the economy, and the best diversification comes fromhaving at least eight stocks in very different businesses.In doing so, it's important to include companies in sectorssuch as energy, mining, and real estate, which bene-fit from inflation. Most stocks suffer during inflationarytimes. Putting approximately 15% of your portfolio inthese inflation-friendly sectors will provide protectionagainst your purchasing power suddenly being eroded.

•Build over time. Even more important than diversifyingamong different types of assets is diversifyingover time. Do you know where the markets are headednext? No one does, but investing money a little at a timecan help even out many of the fluctuations that arebound to happen. Of course, that's easy to do withmutual funds, but not as easy to do when you're decidingon individual stocks. As a strategy, the article suggestsstarting with stocks that appear to be the cheapest.A company's business may remain sound, but its shareprice can decline considerably. As a result, the stocktrades at a price-to-earnings ratio far below its historicalnorm, making it a reasonably cheap stock.

•Keep holding on. There's always the temptation tochange your portfolio in an attempt to own whateverstocks seem to be doing the best. Resist that temptation.The article suggests that ideally, you shouldn't makeadjustments to your portfolio more than once per quarter.In fact, once a year should be sufficient.

The reason for this patience strategy is twofold. First,every time you trade you incur a cost. Second, each timeyou trade, you could be abandoning an underperforminginvestment just before it turns around. With a well-diversifiedportfolio, you shouldn't have to adjust morethan 20% a year.