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Conservative portfolio - the plan

A conservative portfolio is one that's designed for the longer term – typically five to ten years – and is comprised mainly of big, established companies with steady growth prospects and relatively low risk.

It is the right kind of portfolio for you if you want minimal risk and are determined to get back all the money you have invested – for example to fund your retirement – and would also like to earn some dividend income.

Of course there is never a guarantee that you will get back the money that you have invested, however, a conservative portfolio is right for those that want to see their money grow, but also will be prepared to take a limited amount of risk in the form of small-cap or speculative shares.

A conservative portfolio is usually designed to last five to ten years and mainly comprises big, financially stable companies in defensive sectors that pay good dividends.

 

A reasonable growth expectation for a conservative portfolio would be around 6% per year, although this will vary from year to year within its life span.

The process

Building a conservative portfolio takes time, commitment and a lot of research. It's a relatively straightforward process though, which can be broken down into some simple steps.

The first stage is designing the basic framework for your portfolio: deciding on its life span and what percentage of your total investment will be taken up by different sectors and different kinds of companies.

This mix will determine the overall risk attached to your portfolio and how much it is likely to grow. We will discuss this in more detail in this lesson.

The next stage is working out the detail: deciding which specific companies you will invest in to achieve your desired level of exposure to a sector, for example. We will discuss this in more detail in the next lesson.

Make a list of your expenses

As a conservative investor, you commit for the long term, aiming to watch your investments grow steadily over five to ten years.

As you start to build your portfolio, first make a list of any big expenses you will have over the next five years. Put money aside so that you can access it quickly for these expenses.

This will reduce the temptation to dip into your long-term stock portfolio, which could distort the careful asset balance you have achieved and increase dealing costs by exiting positions.

Make regular contributions

Once your portfolio is up and running, it pays to invest regularly. By drip feeding money into your portfolio, rather than bulk buying shares once a year, you can smooth out the average price at which you invest in shares.

Although buying shares in large quantities does reduce your dealing costs, the danger is that you end up buying $10,000 worth of a company's shares, for example, on the single day when their price is 20% higher than their average price over the rest of that year.

Doing this just a few times could have a big negative impact on the ultimate value of your portfolio.

Drip feeding money into your portfolio, rather than bulk buying shares once a year, will help you smooth out the average price at which you invest in shares.

 

Choose at least 15 stocks

Investment professionals are divided over what is the optimal number of companies to have represented in a well-diversified portfolio.

Twenty years ago, ten companies were considered sufficient if an investor wanted to make sure that when one stock under performed, other stocks would compensate.

As stock markets have become more volatile however – and hence the chance of one or more companies experiencing big price falls – a minimum of 15 is now a more usual recommendation.

Most professional traders now recommend that your portfolio contains shares in at least 15 different companies so that it is properly diversified.

 

Quality not quantity

Although some investors with very large portfolios can accommodate up to 200 different stocks, some analysts argue that there is little benefit in individual investors holding more than 40.

At this point, they argue, the benefit that each additional stock adds in terms of reducing risk is minimal.

One thing that everyone agrees on, however, is that having a good number of stocks in your portfolio is essential.

Diversify into different companies

In the same way that investing in a broad range of sectors will help protect your portfolio against downturns in one part of the economy, owning shares in a broad range of companies will help protect your investment from single-stock fluctuations.

Owning shares in a broad range of copmanies will help protect your portfolio against single stock fluctuations.

 

Even if you have carefully balanced your portfolio to include certain ratios of certain business sectors, it is possible that one company within an industry will suddenly underperform its peers, regardless of how well you have done your initial analysis. And sometimes this underperformance can last as long as the life of your portfolio.

Shares in BP, for example, were trading at just over $60 per share in March 2007. By March 2013, they had fallen to just over $40, representing a 33.3% decline.

No investor could have predicted the Macondo OIL spill that triggered most of the damage to BP's share price. The fact remains, however, that an investor with a five-year portfolio who bought BP shares in 2007 could have taken a big hit had BP represented more than 6% or 7% of their portfolio.

Building the portfolio

To achieve the right risk-to-reward balance for conservative growth, you need to weight your portfolio carefully. You also need to diversify in terms of different sectors and geographies.

The following provides you with a guide line in how to diversify your portfolio to include a number of different company types and from different sectors. Note that a company may fall into one or more of the following categories.

Distribution by company size

Large-cap companies: 60-70%

Large-cap or so-called blue-chip companies may have lower growth potential than small-caps and start-ups but they are typically financially strong, are regular dividend payers and have been tried and tested throughout numerous economic cycles.

Large-cap companies should account for 60-70% of your portfolio.

 

You should therefore consider making such companies account for 60-70% of your portfolio.

Mid-cap companies: 15-20%

Mid-cap companies could account for around 15-20%. These companies offer better growth potential than large cap companies, but still offer stability.

Mid-cap companies should account for about for 15-20% of your portfolio.

 

Small-cap companies: 10%

These kinds of companies are a bigger risk but if you strike lucky they could significantly outperform the wider stock market and drive growth in your portfolio.

Value versus growth companies

Growth companies: 15%

You also want to make sure that you have a mix of different stock classes. As identified earlier, you should have a mix of both growth and value stocks in your portfolio. This is because they tend to fall in or out of favour with markets at different times.

Value/income stocks should account for up to 85% of your portfolio. These kind of companies pay better dividends than growth stocks.

 

Value companies: 85%

Conservative investors however tend to have a bigger proportion of value (also known as income) stocks – typically up to 85% of their portfolio.

These stocks pay better dividends than growth stocks and are often the same blue-chip companies that we just discussed.

Defensive versus cyclical companies

Defensive companies: 60-70%

A conservative portfolio will usually contain 60-70% companies in so-called defensive sectors. These are industries whose goods and services tend to remain in demand even during an economic downturn – for example utilities. This means their share prices tend to remain stable even in difficult times.

Defensive companies should account for about 60-70% of your portfolio.

 

Cyclical companies: 30-40%

Cyclical companies will, however, also be represented, with around a 30-40% weighting.

Cyclical companies should account for about 30-40% of your porfoltio.

 

Cyclical shares are those that tend to outperform the overall stock market when an economy is expanding – for example banking stocks – but tend to take a bigger hit during downturns.

An investor will therefore need to perform any initial analysis particularly carefully when choosing which cyclical stocks to include. You should look for companies in these sectors that appear to have much stronger prospects than their peers or which have strong enough balance sheets to endure a prolonged downturn.

Domestic versus overseas companies

It is generally safer to invest in companies that are listed on your home stock market. This is because overseas-listed companies expose investors to currency risk and some stock markets – for example in emerging markets – are more volatile.

For this reason, most conservative portfolios mainly comprised of stocks listed in the same country you are from.

Overseas-listed shares can be more volatile and will expose you to currency risk.

 

And when conservative investors do buy overseas-listed stocks, they are usually the shares of well established international players with a huge market share and consistent growth record – for example Coca Cola.

 

Summary

In this lesson you have learned that ...

  • … a conservative portfolio is one that is designed for the longer term and is comprised mainly of big, established companies with steady growth prospects and relatively low risk.
  • … a reasonable growth expectation for a conservative portfolio would be around 6% per year, although this will vary from year to year within its life span.
  • … a conservative investor usually commits for five to ten years.
  • … investing regularly will help smooth out the average price at which you buy shares.
  • … to ensure your portfolio is diversified, most investment professionals recommend it contains at least 15 different stocks.
  • … conservative portfolios typically contain 60-70% large-cap stocks, plus 15-20% mid-cap and 10% small-cap stocks.
  • … conservative portfolios typically contain 85% value stocks and 15% growth stocks.
  • … conservative portfolios typically contain 60-70% defensive stocks, plus 30-40% cyclical stocks.
  • … conservative portfolios typically contain mostly UK or domestic-listed stocks.