Did you know that creating wealth through equities is actually a very systematic process? As much as it is about stock selection and diversification, wealth creation is also about discipline and determination. If wealth creation through equities is a dialectic process, here is a 3-step approach…
The 3-step process to equity portfolio creation
First understand why you need an Equity portfolio; to build long-term wealth. Remember, equity is the only asset class that can better inflation consistently over a longer time frame. That is because of equity’s inherently ability to compound wealth.
Secondly, when it comes to wealth creation you start with the end in mind. Fix the target corpus you want to build, the amount you will start with, and how much you will invest every month.
Thirdly, understand that your focus should be on managing risk since returns will take care of themselves. You can control what to buy and hold in the portfolio and the amount of risk you can take. You can control the kind of companies that you put into the portfolio. What returns you receive in a given year is difficult to control, but long-term returns will be driven by the performance of the companies in your portfolio, and on your ability to mitigate as many risks as possible.
The essentials of wealth creation through equities…
When you buy a stock, you become part-owner of the company. Therefore you need to approach your equity portfolio the way you will approach your own business venture. Ask yourself “Does this company have a track record of stable and growing revenues and earnings”. This will help eliminate the unstable businesses. Avoid highly leveraged companies as a high debt/equity ratio is a recipe for financial risk getting out of control. Also avoid companies with low historical return on equity (ROE) and companies that are overvalued in P/E and P/BV terms.
Having identified the quality stocks, you need to focus on your portfolio mix. Check if your portfolio has hyper-concentration; that means very few stocks. If your portfolio is just spread across 5-7 stocks in 2 or 3 sectors, then go ahead and add 2 or 3 more sectors with 5-7 companies. This helps you diversify your portfolio risk.
Keep a tab on the percentage-wise allocation to sectors and to individual stocks. You need to avoid concentration risk. Your portfolio must be reviewed at least once in a quarter to check the health of the companies and assess portfolio risk. Do not churn your holdings too frequently as it leads to higher transaction costs and taxes.
Following these steps will be a good start to creating long term wealth through the power of equities. At least, you would have commenced your journey towards being a savvy investor.