The stock market and its potential for risk daunt many people. However, a well-built stock portfolio is likely to outperform the other investments over time. It is possible to build a stock portfolio yourself, but even if you work with a stockbroker, knowing your goals and understanding the nature of the market will help you build a successful portfolio. Given below are tips to evaluate stocks and build a portfolio.
Method 1 of 2: Portfolio-building strategies
1. Commit to invest over the long term.
It is possible to make “a killing in the market” by owning a fast-rising stock for a short period of time, but that sudden gain can be wiped out by an equally sudden loss. A sustained presence in the market is more likely to pay off over time than trying to make a quick buck.
*As part of investing for the long term, determine the amount of money you can afford to commit to the stock market for five years or longer and set that aside for investing. Money you’ll need in a shorter period of time should be invested in shorter-term investments such as money-market accounts.
2. Understand the different kinds of stocks.
Stocks represent an ownership stake in the company that issues them. The money generated from the sale of stocks is used by the company for its capital projects and the profits generated by the company’s operation may be returned to investors in the form of dividends. Stocks come in two varieties: normal stocks and preferential stocks. Preferential stocks are so called because holders of these stocks are paid dividends before owners of normal stocks. Most stocks, however, are normal stocks, which can be subdivided into the categories below:
Growth stocks – Stocks projected to increase in value faster than the rest of the market, based on their prior performance record. They may entail more risk over time but offer greater potential rewards in the end.
Income stocks – Stocks that pay better dividends than other stocks.
Value stocks – Stocks that are “undervalued” by the market and can be purchased at a price lower than the underlying worth of the company. The theory is that when the market “comes to its senses”, the owner of such a stock would stand to make a lot of money.
Defensive stocks – Shares in companies whose products and services people buy, no matter what the economy is doing. They include the stocks of food and beverage companies, pharmaceutical companies and utilities (among others).
Cyclical stocks – These stocks rise and fall with the economy. They include stocks in such industries as airlines, chemicals, home building and steel manufacturers.
Speculative stocks – A stock with a high degree of risk.
3. Develop an investment strategy that meets your goals.
Decide what type of stock portfolio is most important to meet your overall financial goals.
n If making a lot of money over time is important to you, you’ll want to build a stock portfolio of largely growth stocks, with some blue-chip and income stocks and possibly a few well-timed cyclical stocks.
If you need to earn a continuing income from stocks, you’ll want to build a portfolio composed primarily of income stocks, with some blue-chip and defensive stocks for balance.
Understand that your financial goals may change over time, and adjust your portfolio accordingly. Generally, the younger you are, the more risk you can take. You may be better served with a growth-oriented portfolio. The older you become, the more you’ll think about retirement income and may be better served with an income-oriented portfolio.
4. Diversify your holdings.
Regardless of whether you pursue a growth-oriented or income-oriented strategy, you should rely on more than one or two stocks to make up your portfolio. Investing in multiple stocks spreads your risk over various companies, possibly within various industries and classes of stock. Ideally, poor performance by one or two stocks will be offset by significant gains in your other stocks.
5. Invest regularly.
Just as saving regularly can build your bank balance, investing regularly can build your portfolio over time. Buying stock on a regular basis lets you take advantage of rupee-cost-averaging, which allows you to buy more shares per rupee during times when stock prices are low and take advantage of the increased value when prices are high.
Method 2 of 2: Evaluating stocks for your portfolio
1. Look at the price-to-earnings ratio.
The price-to-earnings (P/E) ratio can be identified as either the stock’s current price against its earnings per share for the last 12 months (“trailing P/E”) or its projected earnings for the next 12 months (“anticipated P/E”). A stock selling for Rs.10 per share that earns 10 cents per share has a P/E ratio of 10 divided by 0.1 or 100. A stock selling for Rs.50 per share that earns Rs.2 per share has a P/E ratio of 50 divided by two or 25. You want to buy stock with a relatively low P/E ratio.
When looking at the P/E ratio, figure the ratio for the stock for several years and compare it to the P/E ratio for other companies in the same industry as well as for indexes representing the entire market, such as the S& P SL 20 Index.
2. Look at the stock’s book value.
The book value, or shareholders’ equity, is the theoretical amount that stockholders would be paid for each share owned if the company went out of business. Stocks that sell close to or below book value are considered cheap.
Look for reasons a stock would be selling near or below book value. It may mean the stock is undervalued and is a bargain or it may mean that the company is having trouble.
3. Look at the return on equity.
Also called return on book value, this figure is the company’s income after taxes as a percentage of its total book value. It represents how well shareholders are profiting from the company’s success. As with the P/E ratio, you need to look at several years’ worth of returns on equity to get an accurate picture.
4. Look at total return.
Total return includes earnings from dividends as well as changes in the value of the stock. This provides means of comparing the stock with other types of investments.
5. Evaluate the debt-to-equity ratio.
This ratio is the company’s book value divided by its debt. The more money the company pays in bond interest or lines of credit with banks, the less it can invest in its own future, protect itself from downturns or pay dividends. Debt-to-equity ratios vary in different industries and should be compared against other companies within the same industry to gauge whether the ratio is acceptable or excessive.
6. Observe the stock’s volatility.
How much the stock’s price has changed in the past is a good measure of how likely it is to change in the future. One measure of volatility is called “beta”, which compares the fluctuations of an individual stock against those of an index such as the ASPI. The beta of 1.0 means that stock fluctuates to the same extent as the index. A lower beta means it fluctuates less and a higher beta means it fluctuates more than the index.