Building and Maintaining a Portfolio

By Matt Richey (TMF Verve)

ALEXANDRIA, VA (August 17, 1999) -- Today's report is a draft of what will soon be a "Buying Step" in our steps to Rule Maker investing, which are linked on the right side of this page.

Okay, you've paid off all that nasty high-interest debt, you've established a plan for regular savings, and you've familiarized yourself with the Rule Maker investment criteria. You've taken note of some of the products you and your friends are buying and using on a regular basis, and you think you may have a few good investment ideas. Your discount brokerage account is open (or if not, just click over to the Fool's Discount Brokerage Center). Now, you're ready to string together a portfolio of stocks, and you're wondering...

"Where do I start?"

In the paragraphs ahead, we'll seek to answer some of the most common questions that new investors typically face. But first, why don't we set the stage with a quote from a guy who seems to know a thing or two about investing:

"I wouldn't buy any stocks I would not be happy owning if they stopped trading it for three years. If you can find companies that you will want to be an investor in for five or ten years, you'll probably do reasonably well." --Warren Buffett

Thinking long-term -- it's so easy that it's hard. We've said it before, but we'll say it again: The Rule Maker strategy is a long-term approach to the stock market. Stocks are notoriously unpredictable over periods of less than three years, but beyond that, the direction is up more often than not. And, when your investment horizon is 10 years or more, stocks are the only place to be.

Okay, so now that your gaze is set squarely ten or more years from today, you're ready to begin thinking about building a portfolio. With that, let's dive into some questions that may have crossed your mind.

How many stocks should I buy?

You want enough companies to provide diversification, but not too many that you can't follow them all. A good target range is probably between 6 and 15 companies. For the portfolio to be well-diversified, though, you'll want to make sure those companies offer representation from multiple industries. As we mentioned in the step on Finding Ideas, following your own consumption money is a great place to start. Think about the products and services you use across all aspects of your life. A broad array of potential Rule Makers can be found by asking yourself questions, such as:

- Who is my Internet service provider?
- Which bank do I use?
- Who is my discount broker?
- Who makes my prescription drugs?
- What software do I use at work?
- What websites do I go to on a regular basis?
- Which companies make the food and beverages I consume?

In his venerable Beating the Street, Peter Lynch suggests that for every five stocks you pick, three will perform about as expected, one will be a dog, and the other will be a big winner. Consider that when you buy a stock, your losses are limited to 100%, but your gains are potentially infinite. Over time, you can expect your winners to more than make up for your losers -- much more.

Finally, as you consider how many stocks to buy, be sure to consider the impact of commissions. Try to hold your portfolio's commission costs to no more than 2% of your total portfolio, and the lower the better.

What if I only have time to follow one or two companies?

Every individual investor should hold at least one Rule Maker. Whether you're a recent college grad, a Boomer, or a retiree, an investment in a Rule Maker offers the long-term, tax-free compounding that creates wealth. Of course, an initial investment in a single Rule Maker shouldn't make up more than ~20% of your investable savings. So, if you only have time to follow a few companies or if you are building your portfolio one company at a time, then there are several easy ways to add diversification to your portfolio.

One is the mechanical Foolish Four approach. This time-tested strategy has walloped the market more often than not for the past three decades and only takes 15 minutes per year. It draws on heavyweights that are part of the Dow Jones Industrial Average, so you don't have to worry about any of these companies going out of business anytime soon. Additionally, this strategy tends to outperform the market especially when more traditional growth stocks (such as Rule Makers) are out of favor. The only downside to this strategy is that it involves annual trades and, thus, annual capital gains taxes.

An investment alternative that doesn't have the Foolish Four's commission and tax disadvantages is an index-based tracking stock. Sounds complicated, but it isn't. The S&P 500 index, which includes 500 of America's top companies (Microsoft, General Electric, Coca-Cola, etc.), can be bought and sold just like a regular stock. They're called S&P 500 Depositary Receipts (AMEX: SPY), or "spiders." The Nasdaq 100 index, which includes the Nasdaq's 100 largest companies (Microsoft, Intel, WorldCom, Dell, etc.), works the same way, except it is heavily focused on technology companies. It's called the Nasdaq-100 Index Tracking Stock (AMEX: QQQ).

Should I try to "time" my purchases?

Your discount brokerage account is ready to go, flush with cash that you definitely won't be needing anytime soon. You've studied some investment ideas, crunched some numbers, and are satisfied that you've found a few long-term winners. But now you're frozen, your mind wondering, "The market looks due for a correction, maybe I should wait."

The temptation to time the market is immense, but if you try, odds are that you'll fail as often as you succeed. And, in the process, you'll waste a lot of mental energy that could better be used on, say, planning that next family vacation, or watching college football, or getting a sounder night's sleep. Moreover, if you get caught up trying to time your entry point into investments, you'll miss out on one of the more significant advantages of the Rule Maker strategy -- peace of mind.

Once you've set aside savings, and found companies that you'll be happy owning for the next decade, why not go ahead and buy? Be done with it, and let time and the miracle of compounding work its magic. The management team of your newly purchased company can do the worrying about how to drive up sales, expand market share, and make you, the owner, rich.

What about routine maintenance?

On at least an annual basis, you'll want to do a check-up on your companies' business performance, which by the way isn't the same as stock performance. Test each company against the 10 Rule Maker Criteria and look for any signs of weakness. If you find problems, you must determine whether they're potentially fatal. Most likely, the problems will be temporary, such as Coca-Cola's (NYSE: KO) recent global economic woes, and will be resolved.

Rule Makers don't just roll over, so don't be hasty about discarding a great company. The best businesses are few and far between, so once you find these gems, you'll want to hang on tight. One of the more substantial advantages of buy-and-hold investing is the opportunity to defer capital gains taxes into the distant future. Uncle Sam will give you an interest-free loan on this tax obligation as long as you don't sell. By avoiding the monetary costs of churning your account, you'll be substantially more likely to beat the market

But if your research indicates that a competitor is on its way to usurping your Rule Maker's throne, or if some other serious non-resolvable problem arises, then you may need to consider selling. That'll be the topic of tomorrow's report.

As always, if you have any questions, drop a note in one of our Rule Maker folders, linked below. The Rule Maker Beginners board is especially conducive to that question you have in your mind right now, which you might think is too "dumb" to ask. C'mon over -- answers and help are awaitin'.

Finally, here's a little FYI -- the Rule Maker has some pretty cool free e-mail services that are linked at the top-right corner of this page. You can e-mail this article to a friend, or even sign up to get the Rule Maker sent to your e-mail box every night -- free!

Have a great night!