In my previous post I wrote about the basic principles for responsible investing in the share market: how to diverse the investments and lower the risks. In this post I will try to give give my thoughts about the common questions when to buy and sell shares, which I think is really a question about how to build up and manage a portfolio. I will concentrate here on portfolios with only shares as if you understand how shares work it is easier to understand how a shares-based mutual fund work.
To start with, I think it is important that there is no universal answer or strategy that will always tell you when the best time is to invest or deinvest in a certain company or fund. The world is changing all the time and the market with it, so a strategy that might have worked before might not work tomorrow. In the end, it is up to the individual investor to choose what kind of investment strategy might work at this moment. I will here try to help you formulate your own strategy in the same time as you get the ideas of how to construct a stable portfolio.
An investment portfolio, i.e. a group of shares (or other instruments) may of course be composed in may different ways. The basic question here is: suppose you have found 20 interesting companies, how much should you invest in each of the companies? Note that, as I wrote In my previous post about the basics in investing, you might not want to invest in all 20 companies at the same time, but do it over a longer time period (like months) to reduce the risk for buying at local price peaks.
Balancing based on the market values
In an index fund, which is basically a portfolio of shares that are included in a certain index such as the S & P 500 index that describes the 500 largest US companies, the number of shares of the individual companies in the fund is weighted according to the market values of the companies. If e.g. company X has a market value (Share price times the total number of shares in the company) that is 10 % of the sum of the market values of all 500 companies in the S & P 500 index, the fund will invest 10 % of its capital in company X.
Something to take into account when investing in such index funds is that sometimes some individual companies can dominate a certain index the fund is following. For example, the combined market value of Alphabet, Amazon, Microsoft, and Apple is about 20 % (~6 TEUR, i.e. 6e12 EUR) of the combined market value of all S & P 500 companies (~30 TEUR, at the time of writing), so if you today invest in an index fund that follows this index, 20 % of your money will be invested only in these four companies. Your investment will then be very dependent on how these four companies perform and less dependent on the ~455 other companies in this index.
One option for balancing your portfolio is to make your own personal index fund and invest in your chosen 20 companies based on their individual market values. This might be a good idea if the companies are about the same size. If most of your companies are Finnish with market values typically 1-10 GEUR and then one of the companies is one of the world’s largest companies, such as Amazon worth 1.3 TEUR, over 80 % of your investments will be in Amazon, which is not a good balance.
Balancing based on P/E
A useful way to balance a portfolio that I myself have found to be useful is to use the P/E values of the companies. I have earlier written a blog post about the P/E key number and how it can be used to compare the valuation of different kinds of stock companies. Remember that the lower (positive) P/E value a company have, the better. We want to pay less (P) for more earnings (E). What I usually do is to look on the inverted value, 1/(P/E) or E/P, earnings per price. If I have 20 companies that I believe in, I will try to balance my portfolio so that I invest in every company proportionally to their E/P value, compared to the other companies. I first calculate the E/P for each company and then the sum of all E/P values. If e.g. a company has a E/P that is 10 % of the sum of all the E/P values of my 20 companies, I will invest 10 % of my capital in this company.
The idea here is that I want prioritize companies that have high earnings E in relations to their valuations P.
When you have your initial portfolio with 20 companies balanced according to the inverted P/E values, you will notice that the portfolio will very fast over time diverge away from the ideal composition as the prices P will vary during the daily trade on the markets. However, you can easily calculate how much the holdings in every company is over or below the ideal level by comparing to the ideal portfolio and every time you have some money you want to invest you can look at the companies in your portfolio that are below the ideal and invest in them. There is a chance that these companies are undervalued and will rise in value in the future. If you on the other hand need to sell, you can again by looking at the companies that are over-represented in your portfolio, potentially identify over-valued companies that are in a risk of going down in price in the future.
It is also good to keep in mind that P/E values may sometimes change due to temporary things. A company might decide that a certain asset (share in another company or a property) have had a too high value in their books (which would anyway be realized later if they sell the asset) and when they correct this in the accounting it will affect the earnings for that quarter and therefore the P/E value (which would rise in this case). The normal sales of the company might not have changed at all, but because of a temporary accounting correction that the company chooses to do this quarter the earnings will be lower that they else would have been. In a few quarters, the P/E values might very well go down to the normal level again, but an investor that did not understand the origin of the suddenly lower earnings and higher P/E values might have felt compelled to sell. Similarly, companies may also use similar accounting tricks to try to inflate their EPS and P/E values in order to manipulate the market. The careful investor follows the evolution of the P/E values over time of the companies and tries to understand why there are sudden changes by reading the company earnings reports.
Calculating the P/E value of a portfolio
The P/E value is as told before a measure how high the share price of a company is compared tor the earnings of said company or, in other words, how over- or undervalued a certain company is compared to other companies. It is also quite useful to calculate the average P/E value for your own portfolio. If you follow the portfolio P/E value over time (e.g. a year) you will get an indication when the portfolio is overvalued or not enough diversified. You want to keep your portfolio P/E value somehow steady. If it starts to rise too much, you might want to invest in more companies with lower P/E values to get the average P/E value down or sell some of the shares with high P/E values.
The weighted average P/E value of a portfolio is calculated as
where pi is the P/E value of company i, Ki is the amount invested in company i, and the sums are both over all companies i in your portfolio.
Summary
A group of many companies will have a market price that behaves much more calmly than the market price of any individual company. Looking at the e.g. S & P 500 Index over long periods like the last 40 years, there is a strong upwards trend, as seen in the figure below. Similar long time trends can be seen for most other stock index, like the OMXH25 in Finland, OMXS30 in Sweden, or DAX in Germany (You can find these and other indices by googling them). If your companies are well chosen, the value of your portfolio will mirror or outperform the index that describes the same market (if all your companies are e.g. included in OMXH25, you can compare with this index) and in the long term (5-10 year) there is a quite good chance that your portfolio will increased in value.
Why does the value of the stock market go up in the long term? Simply because the economy is all the time growing: New techniques are developed all the time, the world population is growing, the production is continuously improved and increased. A steady state would, on the other hand, mean that nothing of this is happening in the society. The large shocks to the economies are caused by wars, natural disasters and, as recently shown, by epidemics. Financial crises do happen occasionally, but as seen in the S & P 500 graph below, the effects of these are normally smoothed out after a few years as the economies recover.
The idea of an ideally balanced portfolio, whether it is balanced according to the market value or the inverted P/E value, as described above, or according to some other indicator, is to have something to compare to when you are thinking about buying or selling. By comparing to an ideal portfolio based on the inverted P/E, you may get an idea which companies might be overvalued (compared the other companies in your portfolio) or undervalued, and therefore a good idea of which companies to choose for buying or selling, respectively. You still need to understand what the companies are doing and have an idea of what the future prospects for every company in the portfolio are, but the ideally balanced portfolio gives you some additional guidance when it is time to trade.
Ville Jansson, PhD 