6. MANAGING A PORTFOLIO

6.1. Risk Tolerance and Your Personal Portfolio

Many of us would love to manage our own investments, but it can be overwhelming to know where to begin. Do we use stocks, bonds, futures, commodities, or real estate? Should we go long, buy on margin, short a stock, or put everything into CDs?

You could, of course, dive into these topics individually, but if you are trying to manage your own risk, you first have to determine your risk tolerance. From there, you can manage your accounts based on how much risk you want to take on and how much active managing you want to do.

6.1.1. Determining Your Risk Tolerance

Risk tolerance is an incredibly important aspect of getting started in investing. Depending on your age, income, investments, and goals, you will fall into one of five risk categories:

• Very aggressive
• Aggressive
• Balanced
• Conservative
• Very conservative

The easiest way to get a feel for which end of the spectrum you fall is to go by age. If you’re young and just starting your career, you will fall toward the very aggressive side of the spectrum, while if you are older and approaching retirement, then you are likely near the very conservative side. Take a risk tolerance questionnaire to determine exactly where you fall.

There are some slight variations, but managing your risk is similar in all five categories.

6.1.2. Managing Risk as a Very Aggressive Investor

If you qualify as a very aggressive investor, you have things pretty easy. Simply put, you will want all of your investments to be in stocks (equities) and none in bonds (fixed income). Some may argue that having a small portion in bonds is essential, but the truth is, you need the most growth to give your account a huge boost while you’re young. Having a 100 percent equities portfolio also means that you are taking on a lot of risk. To manage that risk, most people will put all of their money in mutual funds. These funds are spread out through hundreds of different stocks and minimize the risk of any one company going bankrupt and ruining the fund.

For example, take Enron — you could have made a ton of money investing everything in this company, but would have lost everything when they went bankrupt. Mutual funds help minimize single-security risk.

Keep in mind that you will still want to have a cash equivalent emergency fund, equity in your house, and other non-investment accounts, so you won’t truly have everything invested in stocks.

6.1.3. Managing Risk as an Aggressive Investor

Similar to the very aggressive investor, as an aggressive investor, you will want to have a large portion of your account invested in equities. However, your account will also incorporate large-cap stocks — those companies that are well established and the risk of failure is minimal — and some bonds. The large caps and bonds won’t grow as quickly as other equities, but if the economy is in a downturn, they won’t drop in value as much either.

Your biggest risk here is similar to that of the very aggressive investor. You want to spread the risk around with mutual funds so you don’t lose everything (or a big portion) in one market downturn. This means that if you have company stock that you have accumulated over the years, it may be time to cash some of that in to redistribute the risk.

An aggressive investor will have an account that is between 70 and 90 percent equities, with the remaining 10 to 30 percent allocated to fixed income.

6.1.4. Managing Risk as a Balanced Investor

Those well into their working careers, but still a decade or two from retirement, will likely be balanced investors. You are done taking substantial risks, and now want steady growth. Your biggest risk is that a huge market downturn (like we saw in 2008 and 2009) could devastate your investments and cause your retirement plans to be thrown off completely.

To combat this risk, you need to move into more equities and possibly look at some alternative investments. Changing your allocation to between 40 and 70 percent equities will minimize a lot of the market fluctuations. When looking at the graph of your investments, the growth will be steadier, but slower than your aggressive counterparts.

Keeping more money in cash while looking into real estate and precious metals will help to keep your account at a more even keel than having everything traditionally invested.

(To learn more about risk and return, see Perspectives on the Risk-Return Relationship.)

6.1.5. Managing Risk as a Conservative Investor

When you have a firm retirement date set, you will likely fall squarely into the conservative investor category. You no longer want the risk of losing large portions of your account, but you still need some risk to grow faster than inflation.

Your allocation will change to between 20 and 40 percent equities. These equities will be almost all large cap (and probably those that pay dividends) to keep the volatility down. Your risk profile changes from the risk of losing money to the risk of your account not growing fast enough. Without the aggressive equities, your account grows more slowly, but it doesn’t drop as much during recessions.

Fortunately, by this period your other life expenses should be minimized (house paid off, school loans gone, kids through college) and you can dedicate more of your income to your investments.

6.1.6. Managing Risk as a Very Conservative Investor

By the time you are within a few years of retirement, your account should become very conservative. You will want very little risk, and your goal may be to simply preserve your money rather than to grow it. You will have things arranged so you can keep up with inflation instead of growing your account.

To essentially negate risk, your account will be up to 20 percent equities. You will want to have several years worth of income invested in cash equivalents (a CD ladder is great for this). The reasoning is that you need to eliminate the risk of a three- to five-year market downturn. You don’t want to draw on your investments when the market is at a low, so during the years it is declining, and subsequently climbing, you pay living expenses from cash savings. When the market has recovered, then you can withdraw funds to replenish your depleted cash sources.

Your most conservative years will be the five before retirement through the five following retirement. During these years, you can’t afford to lose money while you figure out your retirement lifestyle and income needs. After a few years of retirement, you can actually start to take on more risk. Keep in mind that by the age of 80 you likely won’t be spending as much.

The Bottom Line

How much risk you are willing to take is the key to building a portfolio that will meet your needs, but you can’t just assess this once. Every year or two you should re-evaluate your risk tolerance. Then, you should continue to adjust your portfolio as necessary to keep it in line with your risk tolerance.

Everyone’s goals are going to be different, so while these tips for managing risk will work for most people, they won’t work for everyone. Some will want to be more hands on; others will want to be more hands off. Find an investment strategy that is right for you, then make it a point to base your investments on logic rather than emotion. (For more, see Investopedia’s Introduction to Risk Management.)

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6.2. The Importance Of Diversification

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.

Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true and how to accomplish diversification in your portfolio.

6.2.1. Different Types of Risk

Investors confront two main types of risk when investing. The first is undiversifiable, which is also known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange rates, political instability, war, and interest rates. This type of risk is not specific to a particular company or industry, and it cannot be eliminated or reduced through diversification—it is just a risk investors must accept.

FAST FACT

Systematic risk affects the market in its entirety, not just one particular investment vehicle or industry.

The second type of risk is diversifiable. This risk is also known as unsystematic risk and is specific to a company, industry, market, economy, or country. It can be reduced through diversification. The most common sources of unsystematic risk are a business risk and financial risk. Thus, the aim is to invest in various assets so they will not all be affected the same way by market events.

6.2.2. Why You Should Diversify

Let’s say you have a portfolio of only airline stocks. If it is announced that airline pilots are going on an indefinite strike and that all flights are canceled, share prices of airline stocks will drop. That means your portfolio will experience a noticeable drop in value.

If, however, you counterbalanced the airline industry stocks with a couple of railway stocks, only part of your portfolio would be affected. In fact, there is a good chance the railway stock prices would climb, as passengers turn to trains as an alternative form of transportation.

But, you could diversify even further because there are many risks that affect both rail and air because each is involved in transportation. An event that reduces any form of travel hurts both types of companies. Statisticians, for example, would say that rail and air stocks have a strong correlation.

FAST FACT

By diversifying, you’re making sure you don’t put all your eggs in one basket.

Therefore, you would want to diversify across the board, not only different types of companies but also different types of industries. The more uncorrelated your stocks are, the better.

It’s also important to diversify among different asset classes. Different assets such as bonds and stocks will not react in the same way to adverse events. A combination of asset classes will reduce your portfolio’s sensitivity to market swings. Generally, bond and equity markets move in opposite directions, so if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another.

And finally, don’t forget: location, location, location. Diversification also means you should look for investment opportunities beyond your own geographical borders. After all, volatility in the United States may not affect stocks and bonds in Europe, so investing in that part of the world may minimize and offset the risks of investing at home.

6.2.3. Problems with Diversification

While there are many benefits to diversification, there may be some downsides as well. It may be somewhat cumbersome to manage a diverse portfolio, especially if you have multiple holdings and investments. Secondly, it can put a dent in your bottom line. Not all investment vehicles cost the same, so buying and selling may be expensive—from transaction fees to brokerage charges. And since higher risk comes with higher rewards, you may end up limiting what you come out with.

There are also additional types of diversification, and many syntheticinvestment products have been created to accommodate investors’ risk tolerance levels. However, these products can be very complicated and are not meant to be created by beginner or small investors. For those who have less investment experience, and do not have the financial backing to enter into hedging activities, bonds are the most popular way to diversify against the stock market.

Unfortunately, even the best analysis of a company and its financial statements cannot guarantee it won’t be a losing investment. Diversification won’t prevent a loss, but it can reduce the impact of fraud and bad information on your portfolio.

6.2.4. How Many Stocks You Should Have

Obviously, owning five stocks is better than owning one, but there comes a point when adding more stocks to your portfolio ceases to make a difference. There is a debate over how many stocks are needed to reduce risk while maintaining a high return.

The most conventional view argues that an investor can achieve optimal diversification with only 15 to 20 stocks spread across various industries.

KEY TAKEAWAYS

• Diversification reduces risk by investing in investments that span different financial instruments, industries, and other categories.
• Risk can be both undiversifiable or systemic, and diversifiable or unsystemic.
• Investors may find balancing a diversified portfolio complicated and expensive, and it may come with lower rewards because the risk is mitigated.

The Bottom Line

Diversification can help an investor manage risk and reduce the volatility of an asset’s price movements. Remember, however, that no matter how diversified your portfolio is, risk can never be eliminated completely.

You can reduce the risk associated with individual stocks, but general market risks affect nearly every stock and so it is also important to diversify among different asset classes. The key is to find a happy medium between risk and return. This ensures you can achieve your financial goals while still getting a good night’s rest.

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6.3. How to Calculate Your Portfolio’s Investment Returns

Return on investment (ROI) is one measure of an investment’s success. It directly measure the return on that investment relative to its cost. To calculate ROI, the return of an investment is divided by its cost. This is useful as a crude gauge of how effective an investment is to a portfolio. This method can also be used to measure and evaluate an entire portfolio.

6.3.1. Calculating Returns for an Entire Portfolio

The first step in calculating returns for your investment portfolio is identifying and gathering the requisite data. Once you have the data prepared, there are several considerations to make before performing the calculations.

Begin by defining the time period over which you want to calculate returns (daily, weekly, monthly, quarterly or annually). You need to strike a net asset value (NAV) of each position in each portfolio for those time periods and note any cash flows, if applicable.

6.3.2. Holding Period Return

Once you have defined your time periods and summed up the portfolio NAV, you can begin calculations. The simplest method to calculate a basic return is called the holding period return. It simply calculates the percentage difference from period to period of the total portfolio NAV and includes income from dividends or interest.

Holding period return/yield is a useful tool for comparing returns on investments held for different periods of time.

6.3.3. Adjusting for Cash Flows

If money was deposited or withdrawn from your portfolios, you will need to adjust for the timing and amount of cash flows. For example, when calculating a monthly return, if you deposited $100 in your account mid-month, the portfolio end-of-month NAV has an additional $100 that was not due to investment returns. This can be adjusted using various calculations, depending on the circumstances. For example, the modified Dietz method is a popular formula to adjust for cash flows. Using an internal rate of return (IRR) calculation with a financial calculator is also an effective way to adjust returns for cash flows. IRR is a discount rate that makes the net present value zero. It is used to measure the potential profitability of an investment.

6.3.4. Annualizing Returns

For multi-period returns, a common practice is to annualize returns. This is done to make the returns more comparable across other portfolios or potential investments. It allows for a common denominator when comparing returns.

An annualized return is a geometric average of the amount of money earned by an investment each year. It shows the what could have been earned over a period of time if the returns had been compounded. Annualized return does not give an indication of volatility experienced during the corresponding time period. That volatility can be better measured using standard deviation.

Example

For example, the sum total of the positions in a brokerage account is $1,000 at the beginning of the year and $1,350 at the end of the year. There was a dividend paid on June 30. The account owner deposited $100 on March 31. The return for the year is 16.3% after adjusting for the $100 cash flow into the portfolio one-quarter of the way through the year.

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6.4. What Are Corporate Actions?

6.4.1. De-coding the stock split, merger, spin-off and more

When a publicly-traded company issues a corporate action, it is doing something that will affect its stock price. If you’re a shareholder or considering buying shares of a company, you need to understand how an action will affect the company’s stock. A corporate action can also tell you a great deal about a company’s financial health and its short-term future.

Examples

Corporate actions include stock splits, dividends, mergers and acquisitions, rights issues and spin-offs. All of these are major decisions that typically need to be approved by the company’s board of directors and authorized by its shareholders.

6.4.2. The Stock Split

A stock split, sometimes called a bonus share, divides the value of each of the outstanding shares of a company. A two-for-one stock split is most common. An investor who holds one share will automatically own two shares, each worth exactly half the price of the original share.

So, the company has just cut its own stock price in half. Inevitably, the market will adjust the price upwards the day the split is implemented.

The effects: Current shareholders are rewarded, and potential buyers are more interested.

Notably, there are twice as many common stock shares out there than there were before the split. Nevertheless, a stock split is a non-event, because it does not affect a company’s equity or its market capitalization. Only the number of shares outstanding changes.

Stock splits are gratifying to shareholders, both immediately and in the longer term. Even after that initial pop, they often drive the price of the stock higher. Cautious investors may worry that repeated stock splits will result in too many shares being created.

6.4.3. The Reverse Split

A reverse split would be implemented by a company that wants to force up the price of its shares.

For example, a shareholder who owns 10 shares of stock valued at $1 each will have only one share after a reverse split of 10 for one, but that one share will be valued at $10.

A reverse split can be a sign that the company’s stock has sunk so low that its executives want to shore up the price, or at least make it appear that the stock is stronger. The company may even need to avoid getting categorized as a penny stock.

In other cases, a company may be using a reverse split to drive out small investors.

6.4.4. Dividends

A company can issue dividends in either cash or stock. Typically, they are paid out at specific periods, usually quarterly or annually. Essentially, these are a share of the company profits that are being paid to owners of the stock.

Dividend payments affect the equity of a company. The distributable equity (retained earnings and/or paid-in capital) is reduced.

A cash dividend is straightforward. Each shareholder is paid a certain amount of money for each share. If an investor owns 100 shares and the cash dividend is $0.50 per share, the owner will be paid $50.

A stock dividend also comes from distributable equity but in the form of stock instead of cash. If the stock dividend is 10%, for example, the shareholder will receive one additional share for every 10 owned.

If the company has a million shares outstanding, the stock dividend would increase its outstanding shares to a total of 1.1 million. Notably, the increase in shares dilutes the earnings per share, so the stock price would decrease.

The distribution of a cash dividend signals to an investor that the company has substantial retained earnings from which shareholders can directly benefit. By using its retained capital or paid-in capital account, a company is indicating that it expects to have little trouble replacing those funds in the future.

However, when a growth stock starts to issue dividends, many investors conclude that a company that was rapidly growing is settling down for a stable but unspectacular rate of growth.

6.4.5. Rights Issues

A company implementing a rights issue is offering additional or new shares only to current shareholders. The existing shareholders are given the right to purchase or receive these shares before they are offered to the public.

A rights issue regularly takes place in the form of a stock split, and in any case can indicate that existing shareholders are being offered a chance to take advantage of a promising new development.

6.4.6. Mergers and Acquisitions

A merger occurs when two or more companies combine into one with all parties involved agreeing to the terms. Usually, one company surrenders its stock to the other.

When a company undertakes a merger, shareholders may welcome it as an expansion. On the other hand, they could conclude that the industry is shrinking, forcing the company to gobble up the competition to keep growing.

In an acquisition, a company buys a majority stake of a target company’s shares. The shares are not swapped or merged. Acquisitions can be friendly or hostile.

A reverse merger is also possible. In this scenario, a private company acquires a public company, usually one that is not thriving. The private company has just transformed itself into a publicly-traded company without going through the tedious process of an initial public offering. It may change its name and issue new shares.

6.4.7. The Spin-Off

A spin-off occurs when an existing public company sells a part of its assets or distributes new shares in order to create a new independent company.

Often the new shares will be offered through a rights issue to existing shareholders before they are offered to new investors. A spin-off could indicate a company ready to take on a new challenge or one that is refocusing the activities of the main business.

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6.5. Why Dividends Matter To Investors

“The only thing that gives me pleasure is to see my dividend coming in.” –John D. Rockefeller.

One of the simplest ways for companies to communicate financial well-being and shareholder value is to say “the dividend check is in the mail.” Dividends, those cash distributions that many companies pay out regularly from earnings to stockholders, send a clear, powerful message about future prospects and performance. A company’s willingness and ability to pay steady dividends over time – and its power to increase them – provide good clues about its fundamentals.

6.5.1. Dividends Signal Fundamentals

Before corporations were required by law to disclose financial information in the 1930s, a company’s ability to pay dividends was one of the few signs of its financial health. Despite the Securities and Exchange Act of 1934 and the increased transparency it brought to the industry, dividends still remain a worthwhile yardstick of a company’s prospects.

Typically, mature, profitable companies pay dividends. However, companies that do not pay dividends are not necessarily without profits. If a company thinks that its own growth opportunities are better than investment opportunities available to shareholders elsewhere, it often keeps the profits and reinvests them into the business. For these reasons, few “growth” companiespay dividends. But even mature companies, while much of their profits may be distributed as dividends, still need to retain enough cash to fund business activity and handle contingencies.

The progression of Microsoft (MSFT) through its life cycle demonstrates the relationship between dividends and growth. When Bill Gates’ brainchild was a high-flying growing concern, it paid no dividends but reinvested all earnings to fuel further growth. Eventually, this 800-pound software “gorilla” reached a point where it could no longer grow at the unprecedented rate it had maintained for so long.

So, instead of rewarding shareholders through capital appreciation, the company began to use dividends and share buybacks as a way of keeping investors interested. The plan was announced in July 2004, nearly 18 years after the company’s IPO. The cash distribution plan put nearly $75 billion worth of value into the pockets of investors through a new 8-cent quarterly dividend, a special $3 one-time dividend, and a $30 billion share buyback program spanning four years. In 2018, the company is still paying dividends with a yield of 1.8%.

6.5.2. The Dividend Yield

Many investors like to watch the dividend yield, which is calculated as the annual dividend income per share divided by the current share price. The dividend yield measures the amount of income received in proportion to the share price. If a company has a low dividend yield compared to other companies in its sector, it can mean two things: (1) the share price is high because the market reckons the company has impressive prospects and isn’t overly worried about the company’s dividend payments, or (2) the company is in trouble and cannot afford to pay reasonable dividends. At the same time, however, a high dividend yield can signal a sick company with a depressed share price.

A dividend yield is of little importance for growth companies because, as we discussed above, retained earnings will be reinvested in expansion opportunities, giving shareholders profits in the form of capital gains (think Microsoft).

6.5.3. Dividend Coverage Ratio

When you evaluate a company’s dividend-paying practices, ask yourself if the company can afford to pay the dividend. The ratio between a company’s earnings and net dividend paid to shareholders – known as dividend coverage – remains a well-used tool for measuring whether earnings are sufficient to cover dividend obligations. The ratio is calculated as earnings per share divided by the dividend per share. When coverage is getting thin, odds are good that there will be a dividend cut, which can have a dire impact on valuation. Investors can feel safe with a coverage ratio of 2 or 3. In practice, however, the coverage ratio becomes a pressing indicator when coverage slips below about 1.5, at which point prospects start to look risky. If the ratio is under 1, the company is using its retained earnings from last year to pay this year’s dividend.

At the same time, if the payout gets very high, say above 5, investors should ask whether management is withholding excess earnings, not paying enough cash to shareholders. Managers who raise their dividends are telling investors that the course of business over the coming 12 months or more will be stable.

6.5.4. The Dreaded Dividend Cut

If a company with a history of consistently rising dividend payments suddenly cuts its payments, investors should treat this as a signal that trouble is looming.

While a history of steady or increasing dividends is certainly reassuring, investors need to be wary of companies that rely on borrowings to finance those payments. Take the utilities industry, which once attracted investors with reliable earnings and fat dividends. As some of those companies were diverting cash into expansion opportunities while trying to maintain dividend levels, they had to take on greater debt levels. Watch out for companies with debt-to-equity ratios greater than 60%. Higher debt levels often lead to pressure from Wall Street as well as from debt-rating agencies. That, in turn, can hamper a company’s ability to pay its dividend.

6.5.5. Great Disciplinarian

Dividends bring more discipline to management’s investment decision-making. Holding onto profits might lead to excessive executive compensation, sloppy management, and unproductive use of assets. Studies show that the more cash a company keeps, the more likely it is that it will overpay for acquisitions and, in turn, damage shareholder value. In fact, companies that pay dividends tend to be more efficient in their use of capital than similar companies that do not pay dividends. Furthermore, companies that pay dividends are less likely to be cooking the books. Let’s face it, managers can be awfully creative when it comes to making earnings look good. But with dividend obligations to meet twice a year, manipulation becomes that much more challenging.

Finally, dividends are public promises. Breaking them is both embarrassing to management and damaging to share prices. To tarry over raising dividends, never mind suspending them, is seen as a confession of failure. (For related insight, see “5 Reasons Why Dividends Matter to Investors.”)

6.5.6. A Way to Calculate Value

Another reason why dividends matter is dividends can give investors a sense of what a company is really worth. The dividend discount model is a classic formula that explains the underlying value of a share, and it is a staple of the capital asset pricing model which, in turn, is the basis of corporate financetheory. According to the model, a share is worth the sum of all its prospective dividend payments, “discounted back” to their net present value. As dividends are a form of cash flow to the investor, they are an important reflection of a company’s value.

It is important to note also that stocks with dividends are less likely to reach unsustainable values. Investors have long known that dividends put a ceiling on market declines.

6.5.7. The Bottom Line on Why Dividends Matter

The bottom line is that dividends matter significantly. Evidence of profitability in the form of a dividend check can help investors sleep easily. Profits on paper say one thing about a company’s prospects; profits that produce cash dividends say another thing entirely.