Shares are not just bought, they are employed to do a job – to create capital gain, or generate income – and if they’re not doing that job, they shouldn’t be there.
Ian Murdoch, managing director at advisory firm Investstone Wealth Management, says thinking like a professional investor requires you firstly to define your strategy. “From the outset you must be very clear as to your objectives: what sort of returns you want to achieve from your portfolio, and over what timeframe; whether you’re capital growth-oriented or yield-oriented, or a mix.
“You’ve got to have a strategy before to allocate the assets. You’ve got to set objectives and timeframes and benchmarks. Then choose the ‘style’ you want to follow – value, growth or income. Only then do you come to choosing the actual stocks.”
Tim Farrelly, managing director of Farrelly’s, which advises dealer groups on asset allocation, says an investor seeking to manage their portfolio professionally must understand that they are competing against other professional investors. “Fund managers certainly understand this.
“An active managed fund will buy a stock based on their research, because they think they know something about it that the market doesn’t know, and wait for what they know about the stock to be known by the rest of the market, which will then re-rate it. That’s active management.”
Farrelly accepts that a lot of investors want to run their share portfolios themselves, and not have to use managed funds. “That’s OK, but if you want to do it yourself, but you can’t identify something that you know about the stock that the market doesn’t know, you need to manage the risk. You will need a broadly diversified portfolio – because the concentration risk is too great.”
He says investors must ask themselves, ‘how many stocks do I have to hold so that no one or two stocks blowing up will hurt me too much?’ You need at least 20 stocks to have a broad enough spread to protect against concentration risk, he adds.
Murdoch considers 15 stocks “about right”: if you get beyond that, he says, you start replicating exposures. “You end up getting the same return from different companies. Too many retail investors own all of the big four banks – they keep buying and don’t sell. It’s too dangerous, as we’ve seen in the past six months: that overweight has caused a lot of pain.”
Jeremy O’Gorman, senior client adviser at broking firm Joseph Palmer & Sons, advocates 20 stocks at the most, with asset allocation constantly monitored. “Say for a $100,000 portfolio, I would buy at the most 20 stocks – 5 per cent in each stock. But if the weighting of one stock gets too high, you should take some money off the table and re-weight – put it either into a new stock or into other stocks that might be below that 5 per cent.”
He says a client could have bought Rio Tinto at $70 three years ago, and the stock has risen to $150. “All of a sudden, that 5 per cent holding has become 10 per cent. We would reduce that holding to 5 per cent and re-allocate that money. You’ve got to constantly monitor the asset allocation and the valuation.”
Travis Morien, principal of Australian Independent Financial Advisers (AIFA), says investors have to be “disciplined and ruthless” when it comes to selling stocks. “Selling is as much a key to portfolio management as buying. You should have an idea of the return you expect from a share when you buy it, and be prepared to sell if it has achieved that – and not fret over the possibility that there might be more gains to come.
“If you’re not happy with the prospects of the stock at the current price, it’s a sell. Fund managers are continually asking themselves this question, and so should you.”
Morien sees too many investors fretting over capital gains tax. “This is probably the most unprofessional thing that retail investors can do – not sell because it means they have to pay capital gains tax (CGT). Paying capital gains tax means you’ve made a gain. It is simply a cost of successful investment. Realise the gain, pay the tax and move on.”
He says discipline is just as important when selling will realise a loss. “Crystallising a capital loss has significant tax advantages. It’s very important to overcome the emotional feeling of clinging on to a stock because you don’t want to realise a loss. That simply should not be a consideration.”
Most importantly, says Morien, investors must try wherever possible to take advantage of the CGT discount. Capital gains on assets that have been owned for more than 12 months are taxed at half the investor’s marginal tax rate: but capital gains on assets that have been owned for less than 12 months incur full tax.
“Try to make sure that the stock is held for more than 12 months, to get the discount. That means being able to identify which are the best ‘lots’ of shares to sell from a tax perspective. You can’t always do that: sometimes a stock purchase is a mistake and you might need to get out of it before 12 months are up, but you should be assessing your investment performance on after-tax returns, over long periods of time,” says Morien.