Building a Bullish Portfolio

Most investors proceed along with their portfolio without the benefit of knowing how those investments have performed during similar markets. Crucial to your financial health is a firm understanding of how various investments perform in relationships to our economy. For instance, higher interest rates may negatively impact the current value of bonds.

The longer you have until the bonds mature, the greater the impact. Likewise, higher interest rates and increasing inflation rates can impact stocks. Ironically, stocks are an excellent long-term inflation hedge, yet short term, they often move downward based on reports of stronger inflation.

The Spill Out Effect

When interest rates move too high because of inflation concerns and the stock market reacts badly to the news, investors should be aware of the spill out effect. This effect comes into play when certificates of deposit and ten-year corporate bonds are paying high yields relative to inflation. An example of an attractive rate for a consumer is a current rate of 8 to 9 percent guaranteed for five to ten years when inflation is running at a 3 percent rate. The real rate of return in this example would be 5 to 6 percent. Investors may start moving their funds out of the stock market to lock in safer rates of return. This could pose a problem for you if you need to liquidate some or all of your stock holdings because fewer buyers could mean lower market prices for your securities. Another event that could cause sell-offs is when interest rates on government bonds are higher than stock market earning yields. All that would be required at this point is a perceived negative environment for stocks. This could be caused by any number of reasons such as poor corporate earnings, higher inflation rates, higher tax rates, political climate, inappropriate government intervention, and global events.

Earnings Matter

Earnings really do matter. If you pay too much for a stock based on potential earnings you could see your share price drop if those future earnings fail to materialise. A helpful tactic is to focus only on stocks that have increased their annual earnings every year over the last five years. You would be well served to search for a company that is consistent from one quarter to the next. Look for stocks that have averaged at least 15 percent increases in earnings each year. Don’t fall into the trap of overpaying for those earnings. If a company’s stock is priced at over 30 times annual earnings, then you may be left holding the stock after others sell off. Using these rules, you should be able to eliminate many of the stocks available today. This will allow you to focus on the more stable companies. There are two things to remember about earnings. First, they can change dramatically from one year to the next. If you expect that a stock will increase its earnings almost every year, then you may not mind paying a high price for such a stock. For instance, if a company increases its earnings by 25 percent per year, its earnings could be expected to double in three years. This is why so many stocks are so pricey today. Investors feel that these companies have their best years ahead of them. Many stock buyers will even argue that stocks are cheap today when you consider the possibility of future earnings. They could be right.

The second important factor about earnings is they are not guaranteed; very seldom will companies pass on those earnings to shareholders. If a company were to pass on all of its earnings, chances are it would be out of business because it would probably not be using the money to develop newer products or services. This being the case, competitors could more readily take over their customers. Therefore, most stockholders will see very little of a stock’s earnings in their pocket. The only way most shareholders will receive money is if they sell their shares to another buyer. Therefore, a stock certificate is, essentially, just a piece of paper. The only way you can profit is if there are other investors willing to purchase these shares from you. If these buyers truly understood the importance of earnings, they may be hard-pressed to pay a higher price for your shares. Imagine, even if a company were willing to distribute all of its earnings each and every year, and that company’s stock were selling at $100 with annual earnings remaining at only a flat $4 per share, it would take you 25 years to receive back your original investment!

Observe Current Market Trends and Make Changes as Needed

Many investors react to changing market news by moving out of their current investment positions into other investments that may be perceived as being better suited to their needs. While moving from one investment vehicle to another or from one investment strategy to another may make sense, you should be careful that you are not moving too frequently or too quickly. By the same token, many investors move too slowly from a failing investment strategy thereby endangering their wealth or, at the very least, hampering their overall return.
Investors will generally be rewarded for paying attention to current trends and their relationship to past history.


For instance, many times the stock market will favour a certain segment of the market such as Bank shares. During other time periods, the market pays far more attention to manufacturing companies. In theory, if you can identify these periods, you could be well suited to take advantage of these trends by shifting your portfolio in that direction. During certain periods, you will observe that stocks are not moving up in price but moving sideways or, worse, downward. These types of markets can be brought on by many different factors including recessions or poor corporate earnings.  Instead of fighting these normal market corrections, you might be better served by increasing your cash positions until you feel the market has bottomed out and then deploying your funds back into the market at that point. Keep in mind that there will be times when you are better off moving assets out of the stock market. When the yield on 20-year government bonds exceeds the average dividend yield of stocks comprising the TTSE Index by more than 5 percent, then you may wish to consider bonds as a better asset choice.  The problem with these strategies is that very few people can truly determine where the market is going, when it has bottomed out, or when it has hit a peak. If you feel you are in this category, as most investors are, then you may wish to take advantage of a strategy called asset allocation. Asset allocation is a fancy term for true diversification.  Is your mutual fund well diversified? The practice of good asset allocation is to spread your investment portfolio among various investment asset classes. These asset classes are typically determined by your risk profile and time frame.

Because stocks typically perform better over time, this asset class will often make up the bulk of an assertive investor’s portfolio. Various stock categories will be added to the investment mixture because not all classes and categories of stocks move in the same direction or at the same rate as others. A prudent course of action then, would be to have your stocks diversified among larger-size companies, midsize companies, and smaller companies. Along with these various stock categories, you may want to consider spreading your stock selections among various investment styles such as growth, blend, and the value approach. In some cases  international stocks would be advisable as well. This is done in such a manner as to ensure that you will participate overall in the stock market’s movements. Not all segments of the stock market move in tandem. This helps prevent the problem of concentrating your entire portfolio in the wrong segment of the market and of missing out on the expected rates of returns that the stock market has delivered over the years. A truly diversified portfolio will have various asset classes involved that will not participate with the other asset classes, but will move in a negatively correlated manner. This opposite correlation effect has the tendency to cancel out other segments of the portfolio in the short term yet may add greatly to the value of the portfolio in the long term. For instance, when larger company stocks are in favour, the smaller company  stocks may be falling in value or lagging in appreciation.

However, when larger stocks are trending downward, you may see smaller stocks back in favour delivering good returns. This effect has the tendency to reduce overall portfolio volatility while preserving a portfolio’s overall long-term return.