In Malta it’s common to know someone who’shad a bad experience investing in the stock market. As a result many of us have become averse to investing in anything other than real estate, government bonds or capital guaranteed products – investments deemed “safe”.

At first glance investing exclusively in bond and real estate holdings may seem prudent – but for many of us it’s not the way to go. An investment portfolio lacking shares of good quality companies, with good earnings prospects, is a portfolio lacking the necessary diversification and “fire power” to assure good long-term investment returns.

Nutritionists often tout the health benefits of eating a well-balanced diet. A diet full of proteins, with few carbohydrates, will leave you lethargic. All four of the major food groups play some part in sustaining us in a healthy and productive way.

The same can be said of an investment portfolio. A balanced portfolio including the four major asset classes – equity, bonds, real-estate and commodities – is to the investor what a well-balanced diet is to the competitive athlete: essential.

Just as the grain complex gives the body energy, owning a broad and diversified portfolio of equities over time will energise your portfolio towards solid returns. Few appreciate that equities are the best performing asset class historically. The S&P500 for example, a diversified index of 500 of the largest US stocks has returned about 10 per cent annually, solidly beating, bond, real-estate and commodity returns. A portfolio devoid of shares will underperform during periods of economic expansion and corporate earnings growth. An underperforming portfolio may keep you from fulfilling your retirement dreams.

Owning a broad and diversified portfolio of equities over time will energise your portfolio towards solid returns

Owning shares of companies implies having a right to a portion of the companies’ earnings; and of course as a company’s earnings grow, generally so too does the value of its shares.

In 1982, Apple Computer generated net earnings of $62 million, whereas in 2012 it earned $42 billion.

An investment of $5,000 (€3,787) put into Apple Computer 30 years ago would be worth $713,000 (€540,000) today! Although few stocks have seen Apple’s earnings growth, your average US stock has grown its earnings at roughly eight per cent a year. Common shares are normally purchased through financial intermediaries and trade on exchanges. By owning shares, you have certain rights, such as: being entitled to dividends; voting for a slate of directors; and certain corporate events.

If you own enough shares you can perhaps control a board seat, and influence in some way, how the company is managed. Should a company declare bankruptcy, the value of common shareholder’s stocks is often worth nothing – yet shareholders can’t lose more than their initial investment.

Many of us have gotten into trouble owning shares, not necessarily because we bought the wrong stock, but because we bought too much of it, relative to our net worth. Imagine Investor A and Investor B, both having an investment portfolio worth €10,000 and both buying XYZ Ltd. Let’s say, Investor A foolishly places all his cash into XYZ, yet Investor B puts just five per cent or €500 into it. Next day, XYZ announces very bad news and the stock plunges 50 per cent. Investor A anxiously loses half his account value, whereas Investor B calmly loses a meagre 2.5 per cent. Although both investors owned the same stock, Investor B mitigated the pain of the selloff by managing risk effectively, and not owning too much of it. It’s critical we manage the size of all our bets and invest in a portfolio of perhaps 10 to 20 stocks to diversify our holdings and spread out risk.

Risk management is by far the most essential element to successful investing! Too many of us overestimate our skills in picking good quality companies which aren’t overvalued. We often buy stocks at prices which already reflect good news - leaving them little impetus to rally further. Also we buy shares after significant rallies, instead of on dips as prices experience normal corrections. Warren Buffet, the legendary billionaire US investor, only buys good quality companies having a competitive advantage, which are priced at a significant discount to intrinsic or fair value. An analogy is to buy an excellent product on sale at a 50 per cent discount to its full price. Savvy investors always buy good companies on sale!

Investing in shares can be tricky if a disciplined approach to screening inexpensive companies with good earnings growth potential isn’t utilised. However, investing with a long-term horizon, managing the size of your bets and having a diversified portfolio should improve the odds of your success significantly.

This is the second in a 10-part investor education series which will be appearing every fortnight.

Joseph Portelli is the managing director and chief investment officer at FMG Funds (Malta). He also is a lecturer at the University of Malta and Institute of Investment Analysis.

Sign up to our free newsletters

Get the best updates straight to your inbox:
Please select at least one mailing list.

You can unsubscribe at any time by clicking the link in the footer of our emails. We use Mailchimp as our marketing platform. By subscribing, you acknowledge that your information will be transferred to Mailchimp for processing.