As the bull run on global sharemarkets accelerates unabated, investors continue to pile in with a herd-like mentality. With this heady rush, I think it’s a good time to remind sharemarket investors of one of the common pitfalls in times like these: over-speculation.
As we’ve witnessed once again, the flow of funds has supercharged dividend-paying stocks, then swung into strong growth stories, and has now inevitably moved to the small end of town – the speculative stocks.
The big run-up in the price and activity of small gold explorers is a classic example of this, driven by the surge in the gold price. It’s easy to see the attraction – one good upgrade by an explorer can send a share price rocketing.
But be warned: when financiers and friends of friends start spruiking small stocks as the next big thing, it often signals an imminent market slide.
Don’t be fooled
The prospect of huge gains is exciting, and sometimes just the chance that your mate – or some paid broking report – might be right is enough to take a punt. But in reality, the odds of a windfall gain on a speculative stock are often no better than buying a lottery ticket.
That’s why I rarely speculate. Of course, that also reflects my age, risk profile, and personal circumstances. There is, however, room for higher risk-reward stocks in a well-balanced portfolio – the key is constructing your portfolio wisely from the outset.
What exactly does that mean?
Look to Egypt
A well-balanced portfolio can be thought of as a pyramid. Starting construction work from the bottom, the base needs to be made of solid stuff. In the share market this means established, cash generating businesses with a sustainable competitive advantage. Almost the exact opposite profile of speculative stocks.
They don’t run up as hard as others in the good times, but don’t slide as hard on the way down either, and in a lot of cases outperform the wider economy.
I’m talking about healthcare, consumer staples, like food, beverages and other household items, and telecommunications. Think CSL, Woolworths and Telstra – traditionally strong stocks in traditionally strong sectors – which pay strong dividend yields.
These types of core stocks will make up the biggest portion of your investment pyramid – anywhere up to about 60 per cent of the whole structure, depending on age and appetite for risk. Only once that base is in place can you start building on it with some growth companies.
These are cash-generating outfits that have room in their industry and business for expansion. They can’t be pegged to a specific industry, but more thought of as a link between the core and speculative stocks that will make up the tip of the pyramid.
These growth stocks might make up 30-40 per cent of the portfolio. And for me, that’s as pointy as my pyramid gets.
But given the solid structure underpinning the pyramid, there is room for anywhere up to 10 per cent of the portfolio to be invested in speculative stocks. Essentially this is money that you can afford to lose, like a lottery ticket.
Share your eggs
Throughout the process of building the portfolio pyramid it’s also important to consider diversifying your investment risks. This means ensuring you don’t have too much exposure to one particular industry, technology, economy or resource.
Of course professional advice is important in any responsible approach to investing too but, as you can see here, just as important is common sense. It’s amazing how many people still put all their investment eggs in one basket, or buy a bunch of businesses that don’t make any money.
Following these simple principles, building a well-balanced portfolio that diversifies risk, will help to eliminate the temptation for speculation.
Because what’s less considered in bull markets (which we’re in now), is that things can get clawed back just as quickly the other way – and it’s the speculative stocks that fall the fastest.
According to my friend’s advice, a market pullback could happen at any time.
