At National Bank Direct Brokerage, clients enjoy access to a number of valuable data sources and sophisticated analytical tools, including the Recognia system. These resources can help you take your investing skills to the next level, moving beyond stock picking to building a portfolio modelled on the best practices of institutional portfolio managers.
You’ll need to take some time to understand and then implement each step of the portfolio construction process, but your efforts should be rewarded by an improvement in your portfolio’s risk/return ratio.
Let’s take a look at the process, step by step.
Start by taking some time to identity your approach to investing, or investment style. No one can be an expert in all types of investing, so it helps to focus on one approach. Here are a few questions to get you started:
This list is not exhaustive, but it gives you an idea of the kind of reflection required to determine your investment style. Having a clearly defined approach to investing helps ensure consistent decision-making. What’s more, it can often help you avoid mistakes by providing a strict framework to keep you on track through rough patches.
The next step is to select good investment opportunities within the parameters you identified in the previous step. If you’re a fan of technical analysis, make a list of the three or four models that you’re most familiar with. If fundamental analysis is more your thing, select five or six indicators that you consider particularly important. In both cases, it’s usually a good idea to diversify model risk: rather than relying on a single indicator, create an index that summarizes the underlying indicators using a “composite” scale.
There are several ways to combine the individual metrics. Here is a simple example: Let’s say that return on equity (ROE) is one of your chosen fundamental metrics. If a company’s ROE puts it in the top 10 percent among comparable companies, you might consider this a buy signal and assign it a score of 1. If, on the other hand, the company’s ROE is very low, you could assign it a score of -1 (sell). If the indicator is inconclusive, assign a score of 0. Follow the same procedure for the other four or five indicators and add up the scores assigned to each. A total of more than 3 would suggest a strong enough consensus to justify a buy recommendation, whereas a total of less than -3 would suggest a sell recommendation. Recognia is a very useful tool at this stage in the process.
Once you’ve determined the best buy and sell opportunities, make sure that the companies in question are not currently involved in a special situation, such as a major restructuring. Toshiba is a recent example of this. It’s usually a good idea to scratch special situations from your list of potential transactions. This is because your indicators may not work reliably in such circumstances, especially if the situation is uncommon.
Once you’ve finished sifting through all those buy and sell signals, you’ll need to make sure your proposed portfolio is well diversified. Your first job is to tidy up your existing portfolio. Check if there are any holdings that should be sold, either because they are no longer growing or because of a change in situation. These positions can be replaced with the most promising new opportunities you’ve identified. If there are no stocks that you want to offload right now, you’ll need either to invest new funds to buy the new stocks or to sell a part of all your other holdings to raise the funds needed.
Once you’ve made these decisions, make sure that the changes don’t result in an unbalanced portfolio, and that the level of diversification is still in line with your expectations. For example, you might sell shares in telecommunications companies and replace them with gold producers. However, if you already had a lot of gold producers in your portfolio, these changes will reduce diversification. This may be what you’re aiming for in the short term, but in this case you should be especially confident in your new signals before going ahead.
Transaction errors are common. Don’t forget to double-check your orders (the number of shares and name of the stock) before submitting them to NBDB.
Once your orders have been placed, check the transaction notices to make sure that everything is correct. We’ll discuss the interesting question of including a stop-loss order when placing buy orders in another article. Finally, although it’s usually advisable to cut your losses when it seems like a transaction was a mistake, it’s also important to have a well-thought-out recovery strategy, otherwise your portfolio may be underinvested for too long.
How often you should monitor your portfolio depends on the frequency with which you trade. For example, if you make three or four trades a week, once a day is the bare minimum, and two or three times a day is preferable. Although it is generally advisable to remain disciplined and stick to your chosen approach, when exceptional circumstances arise, don’t hesitate to go ahead and adjust your portfolio in advance of your next scheduled “rebalancing.”
For example, if a company you own shares in is hit with a major lawsuit—like the one recently filed against Qualcomm by Apple—it is generally advisable to replace the stock. Even if it isn’t certain that the defendant company will lose, events such as these are likely to add unwanted volatility to your portfolio. And if ever you should be tempted to trade based on the headlines, remember that this type of investment is a specialty in itself, and that by adopting this approach you will be going up against very sophisticated investors. It’s risky to think that you can win every battle.
The portfolio construction process outlined in this article is based on the best practices of investment professionals. You may decide to follow your own approach, but by incorporating the six steps above, chances are that you will enjoy more consistent performance.
National Bank Direct Brokerage (“NBDB”) is a division of and a trademark used by National Bank Financial Inc. (“NBF”) for its order-execution services. National Bank Direct Brokerage offers no advice and makes no investment recommendations. The client is solely responsible for the financial consequences of his or her investment decisions. Member of the Canadian Investor Protection Fund.
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