The email from Patrick read:

“Good afternoon. I have a mix of term deposits and shares (Wesfarmers, ANZ, Westpac). I would like to invest more in shares to offset low interest returns on my term deposits.
Your thoughts please”.

Patrick’s email (I have changed his name) is typical of many I get from subscribers asking me about the “how” when it comes to investing money into the stock market. Often, these investors own a couple of shares already, but have the bulk of their monies invested in term deposits and other defensive assets.

And while I want to address the “how”, I am not trying to make a case to put more money into the stock market at the moment. Personally, I am close to fully invested, and while I feel that the market has further to run, we do seem to be moving into the “optimism phase”. So, I am a happy holder.

Let’s go back to the question. How?

Do you want to manage a portfolio of stocks?

This is the first question to answer. If you don’t want to manage a portfolio, then look at a managed investment option (see below).

And by a portfolio, I don’t mean a handful of stocks. I mean at least eight, and probably more likely 15 to 20 stocks drawn from different industries and sectors. The reason for this statement is set out in the graph below, which shows the statistically modelled relationship between the number of stocks in a portfolio and the annualised volatility of the portfolio. Volatility is another word for risk.

Essentially, as you add stocks, the risk in the portfolio reduces, which is what you would expect if you are diversifying against specific company risk. At around eight stocks, the curve starts to flatten out – so that if you add a ninth stock, the reduction in volatility is not that big. By the time you get to 30 stocks, the benefits of adding additional stocks are fairly slim.

This is why most active fund managers have portfolios of around 25 to 35 stocks. They don’t have 200 stocks, and they usually don’t have just 10. For personal investors, it is a little harder, because most of them don’t have the time to focus on 30 or more stocks. I work on the basis of around 15 to 20 stocks.

If you are going to manage your own portfolio of stocks, the next step might be to compare your current exposure to the market’s sector weights, and decide what sectors your additional investment monies should be directed towards. For example, Patrick says that he has three stocks – ANZ, Westpac and Wesfarmers – so it looks like he is very overweight financials and consumer staples, and underweight (zero weight) all other sectors, such as consumer discretionary, materials and industrials.

The table below shows the current sector weights of the 11 first level industry sectors. The financials sector, which includes the four major banks, major insurers, Macquarie, AMP and diversified financials like Challenger, is the largest sector, making up about 38% of the S&P/ASX 200. The smallest sector, Information Technology, accounts for only 1.2%.

Source: S&P Dow Jones as at 30 Nov 16

If Patrick’s portfolio was around 33% to 43% in financials, he would be close to market weight or neutral. Below 33%, he would be considered to be underweight, over 43% he would arguably be overweight.

And it is not to say that he shouldn’t have biases. This is clearly part of the role in managing a portfolio. These biases should be consistent with his investment objectives and potentially will change over time, according to his investment outlook. The point is that they should be considered.

Clearly, some of the sectors are so small that it doesn’t really matter whether you have an exposure or not. However, if you decide (for example) that you don’t want any exposure to any of the very large sectors, such as to the resource sector through materials, then your portfolio risk is quite high. You could seriously underperform compared to the index, or seriously outperform.

Finally, once you have determined your target sector weightings, the next step is to select the stocks you want to invest in and their individual weightings. As a guide, you could look at our income portfolio (shown below), or our growth portfolio (see here).

These portfolios focus on stocks within the top 100. That doesn’t mean that there aren’t great stocks outside this part of the market, it is just that this is one of the portfolio rules we have set with these model portfolios.

And I should point out that there are hundreds of ways to construct a portfolio. I am just illustrating the approach that I follow.

The managed alternative

Don’t want to manage a portfolio of stocks? Then employ a manager to do it.

You can engage a manager who actively selects the stocks, or who passively follows an index, such as the S&P/ASX 200. The latter is generally the modus operandi of exchange traded funds or ETFs. The main advantage of ETFs is their low management fees, combined with the certainty that you will get index performance. They are also quoted on the ASX.

The main ETFs are shown in the following table.

There are also ETFs that cover other parts of the market (such as iShares ISO, which tracks an index for smaller companies, the Small Ordinaries index); market sectors, such as listed property securities (SPDR’s SLF), financials (Betashare’s QFN) or resources (SPDR’s OZR); or investment strategies, such as iShares S&P/ASX Dividend Opportunities (IHD) or Betashare’s Dividend Harvester (HVST).

There are several listed investments that employ an active approach to investment management, including listed investment companies (LICs). The major listed investment companies taking broad based equity exposures are shown below.

There are also LICs that cover other parts of the market, such as the Contango Microcap Ltd (CTN), which invests in microcaps, or Wilson Asset Management Ltd (WAM), which invests in mid-caps and smaller companies.

A key issue when investing in LICs is the premium or discount they are trading at relative to their net tangible asset backing.  At the moment, the broad based LICs are trading very close to par (in some cases at a small discount), so they are relatively attractive on this basis (see here for a discussion on the premium/discount, and a comparison between LICs and ETFs).

There is also a plethora of unlisted equity funds that retail investors can access.

The best of both worlds?

A third option is to consider the hybrid model – use a manager for part of the portfolio, and manage the rest yourself. The “core and satellite” method is a permutation of this approach.

Under “core and satellite”, you often employ a manager to manage the core of the portfolio. While there is no hard rule about how big the core is, it is generally considered to be around 80% of your portfolio. A single ETF or perhaps one or two broad based listed investment companies, could achieve this, depending on your view about investment style.

The other “20%” could be invested in particular stocks that you fancy or perhaps already own; in particular sectors to boost yield (i.e. listed property securities or financials) or to boost portfolio biases (i.e. resources sector); or in smaller companies or microcaps. Perhaps you might even have the odd speculative stock.

Covering off “the how”

Hopefully, this has covered off “how” to invest money in the market. It starts with wanting to make an allocation, and then answering that question about whether you want to manage a portfolio.

But one suggestion: don’t have just three stocks (unless they are part of the satellite component of a core/satellite strategy). Build a portfolio or get a manager.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.