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A simple formula for a successful portfolio

by , 16 January 2014

Two of the most important, fundamental concepts for investing success are diversification and compounding returns. No matter how experienced you are as an investor, it's important to always think about these two ideas when committing your capital. And for beginning investors, the sooner you understand these concepts, the sooner you are on the road to building your wealth. Read on to discover how you can build a successful portfolio…

Compound returns are money you make off the money you make, Dr David Eifrig in Daily Wealth explains...

Let's say you find a share you like that pays a safe, rich 5% dividend yield. You buy 100 shares for R100 each, for a total position value of R10,000. For simplicity, let’s assume the share price and the dividend stay fixed for a long time at R100 and 5%, respectively.

At the end of the first year, you'll receive R500 in dividends (5%). You take that payment and buy five more shares… This increases your position value to R10,500.

In year two, you earn R525 in dividends. You reinvest this, too.

Repeat this process for 12 years. In the twelfth year, your position is worth R17,958.60, and you'll make R855.20 in dividends. That's an 8.55% dividend yield off your initial R10,000 investment.

Diversifying your portfolio is the key to avoiding catastrophic losses

If you're building your own portfolio… it's important to diversify your share holdings across several different business sectors. Sectors post dramatically different returns from year to year (though research shows the differences even out over time).

You need to pick multiple shares and multiple sectors… Shares that will provide returns independent of each other.

For instance, pick a financial services share, a technology share and a company that produces consumer staples. Different factors will influence these companies. They will be unrelated to each other.

Of course, they may all move together if stocks are in a bull market or bear market. That's why holding a variety of asset classes – like bonds – is important.

With one share, you can win big. But you have high risk. You could lose it all. But as you own more and more shares, your risk goes down.

At the same time, the more you own, the more likely you are to earn the "market return".

How to build a portfolio

So for example, a simple, low-risk starter portfolio might include three to five shares from different, unrelated sectors such as consumer spending, technology and financial services. It might also include one or two fixed-income positions, such as retail savings bonds. You'd also want to keep some of your portfolio in cash and in physical gold.

It doesn't take a lot of experience or money to start investing. You can start with as little as R300 a month to work your way to financial independence. Unit trust funds make it easy to diversify and allocate your portfolio to make the most of your money, while keeping it safe.

But if you've got a little bit more money and an interest in learning how to pick your own investments, you can create your own diversified portfolio using the ideas above.

The most important thing to do is just to get started.

So there you have it, a simple formula for a successful portfolio.

A simple formula for a successful portfolio
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