Peter Sharkey - how do you start to build an investment portfolio?
Most investors are understandably loss-averse, though in almost all cases this is a far cry from being risk-averse. People will usually accept a modicum of risk as the necessary consequence of making a possible future gain but even so, losses can have an adverse affect upon capital and an investor's psyche.
Our perception of risk generally has negative connotations. The noun is defined as a hazard, of having bad consequences and of exposing those taking it to the possibility of mischance.
Nowhere in the OED is risk determined to be an essential flip-side of reward, or of constructing a route to possible profitable opportunities, yet these more positive definitions are equally valid.
I mention this not as a prelude to a treatise on investment psychology, but because I've spent a considerable amount of time mulling over a question posed by a reader a few weeks back and felt that an investor's attitude to risk was pivotal to providing a solid answer.
'How do I start and build an investment portfolio,' he asked.
It's a simple enough question which I initially intended answering here with reference to standard deviation and measures such as beta, designed to indicate a market's or a fund's systematic risk.
I soon abandoned this idea though and went instead in search of literary enlightenment, browsing through a variety of books whose themes dealt with financial markets, forecasting, strategies and company analysis. None seemed appropriate or else were simply too intense.
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Online, it's possible to spend hours delving into theories on income strategy, asset allocation, target returns and time horizons, all of which is fascinating and relevant stuff, but it fails to answer our reader's basic question.
Finally, I turned to The Essays of Warren Buffett and there, under a section on intelligent investing, the answer leapt from the page.
As ever, the Sage of Omaha keeps his message simple.
He begins by suggesting that, 'most investors…will find that the best way to own [shares] is through an index fund that charges minimal fees.'
For those who prefer investing directly, Mr Buffett offers sound advice.
'Should you,' he writes, 'choose…to construct your own portfolio, there are a few thoughts worth remembering. Intelligent investing is not complex, though that is far from saying that it is easy. What an investor needs is the ability to correctly evaluate selected businesses. You don't have to be an expert on every company, or even many. You only have to be able to evaluate companies within your circle of competence. The size of that circle is not very important; knowing its boundaries, however, is vital.'
In the space of just one page, the world's most successful investor explains how to start and then build an investment portfolio.
He implores investors to take a longer-term view.
'Your goal,' he continues, '[is] to purchase a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, 10 and 20 years from now. Over time, you will find only a few companies that meet these standards, so when you see one that qualifies, you should buy a meaningful amount of stock.'
It could be argued that before arriving at this simple analytical stage, the would-be investor must assess his attitude to risk, but once he's resolved this, Mr Buffett's words of wisdom offer an essential foundation to building an investment portfolio.