Stock investors are consistently advised to diversify their investments. The concept simply means you should not put all of your eggs in one basket – which in turn helps mitigate risk, and generally leads to better performance or return on investments. Diversifying your hard-earned money might not be a pleasant experience, since an investor needs to expend some amount of effort to determine where to invest their funds.
The good news is that there are different ways of diversifying investment funds. We will look at the following portfolio types: aggressive, defensive, income, speculative and hybrid. It is important to understand that building a portfolio will require research and some effort. Having said that, let’s have a quick look across our five portfolios – to gain a better understanding of each as well as learn some of the most suitable strategies which can be adopted by an investor.
The Aggressive Portfolio
An aggressive portfolio includes those stocks with high-risk/high-reward proposition. Stocks in this category typically have a high beta or sensitivity to the overall market. Higher beta stocks experience larger fluctuations relative to the overall market on a consistent basis. If your individual stock has a beta of 2.0 (A beta is a measure of the riskiness of a security or a portfolio in comparison to the market as a whole. A beta of less than 1 means that the security will be less risky than the market, and a beta greater than 1 indicates that the security’s price will be riskier than the market.), it will typically move twice as much in either direction to the overall market – hence, the high-risk, high-reward description.
Most aggressive stocks are in the early stages of growth and have a unique value proposition. Building an aggressive portfolio requires an investor who is willing to seek out such companies, because most of these names, with a few exceptions, are not going to be common household companies. The most common sector to scrutinise would be technology, but many other firms in various sectors that are pursuing an aggressive growth strategy can be considered.
As you might have gathered, risk-management becomes very important when building and maintaining an aggressive portfolio. Keeping losses to a minimum and taking profit are keys to success in this type of portfolio.
The Defensive Portfolio
Defensive stocks do not usually carry a high beta and are usually fairly isolated from broad market movements. Cyclical stocks, on the other hand, are those that are most sensitive to the underlying economic ‘business cycle’. For example, during recessionary times, companies that make the ‘basics’ tend to do better than those that are focused on luxuries. Despite how bad the economy is, companies which make products essential to everyday life will survive. Think of the essentials in your everyday life, and then find the companies that make these consumer staple products.
The opportunity of buying cyclical stocks is that they offer an extra level of protection against detrimental events. A defensive portfolio is prudent for most investors. A lot of these companies offer a dividend as well, which helps minimise downside capital losses.
The Income Portfolio
An income portfolio focuses on making money through dividends or other types of distribution to shareholders. These companies are somewhat like the safe defensive stocks but should offer higher yields. An income portfolio should generate positive cash flow.
An Income portfolio is a nice complement to most people’s paycheck or other retirement income. Investors should be on the look-out for stocks that have fallen out of favour and have still maintained a high dividend policy. These are the companies that can not only supplement income but also provide capital gains. Utilities and other slow-growth industries are an ideal place to start your search.
The Speculative Portfolio
A speculative portfolio is the closest to a pure gamble. A speculative portfolio presents more risk than any other discussed here. Finance gurus suggest that a maximum of 10% of one’s investable assets be used to fund a speculative portfolio. Speculative ‘plays’ could be initial public offerings (IPOs) or stocks that are rumoured to be takeover targets. Technology or healthcare firms that are in the process of researching a breakthrough product, or a junior oil company which is about to release its initial production results, would fall into this category.
Another classic speculative play is to make an investment decision based upon a rumor that the company is subject to a takeover. One could argue that the widespread popularity of leveraged ETFs in today’s markets represent speculation. Again, these types of investments are attractive as picking the right one could lead to huge profits in a short amount of time. Speculation may be the one portfolio that, if done correctly, requires the most homework. Speculative stocks are typically trades, and not ‘buy and hold’ investments.
The Hybrid Portfolio
Building a hybrid type of portfolio means venturing into other investments such as bonds, commodities, real estate and even art. Basically, there is a lot of flexibility in the hybrid portfolio approach. Traditionally, this type of portfolio would contain blue-chip stocks and some high-grade government or corporate bonds.
A common fixed-income investment strategy approach advocates buying bonds with various maturity dates and is essentially a diversification approach within the bond asset class itself. Basically, a hybrid portfolio would include a mix of stocks and bonds in a relatively fixed allocation proportion. This type of approach offers diversification benefits across multiple asset classes, as equities and fixed income securities tend to have a negative correlation with one another.
At the end of the day, investors should consider all of these portfolios and decide on the right allocation across all five. In the above write-up we have laid the foundation by defining five of the most common types of portfolios. Nevertheless, building an investment portfolio does require more effort than a passive, index investment approach. By doing it alone, you will be required to monitor your portfolio and rebalance more frequently, thus racking-up commission fees. Too much or too little exposure to any portfolio type introduces additional risks. Despite the extra required effort, defining and building a portfolio will increase your investment confidence and give you control over your finances.
Investment Quote for the Week
“Investors should be sceptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the models. Beware of geeks bearing formulas.”
ABOUT OMEGA CAPITAL
Omega Capital Limited is an Investment management, private equity and investment advisory firm. The Company is authorized and regulated by the Securities and Exchange Commission of Ghana.
Kumapremereh Nketiah (JP)
Sophia Obeng- Aboagye
Omega Capital Research
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P.O. Box CT8818
Cantonments – Accra
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