How to create the perfect portfolio

Small-cap share expert Tom Bulford explains how he would construct the perfect portfolio for investing in stocks.

OK, we've talked about the first steps you need to take to become an independent investor. You decide on your online broker. Then you decide what type of account you want whether it's a Sipp, Isa or basic online portfolio.

Then, if you're like me, you scroll down the range of available investment' options to where the action is shares.

As I said last time there are only two pure ways of making money. Firstly, you can lend it in return for a rate of interest; or secondly, you can take ownership of a business that delivers something for which its customers are willing to pay more than the cost of production.

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And where are you most likely to find the companies delivering new and exciting products to their customers? Well, in shares.

With penny shares you get as close as possible to the fount of wealth creation, cutting out all the charges that are normally levied for those derivatives or pooled products. Let me explain why this option is so superior to money lending

What to do with money you cannot afford to lock away

It is foolish to invest any money in the stock market unless you are confident that you won't need it for at least two years. Even the best businesses can fall victim to the market's blues for several months. The longer you leave your money in a share the more its price will be determined by the progress of the underlying business and less by the fluctuations of the market.

For any money that you think you might need within two years, my advice is to stick it in the bank or building society or into an account with National Savings & Investment, an organisation that is in my experience so efficient that it puts all others to shame.

What you need to remember is that the government guarantees deposits of up to £85,000 with any one bank or building society group. So long as you are within that limit, the rate of interest that you get is basically dependent upon the amount of money you can deposit and the length of time that you can leave it.

Shop around a bit and do your best. But let's face it, interest rates are very low and the difference between getting 1% or 2% on your money is hardly going to make much difference.

How to get the most out of investing

For any money that you can invest for at least two years then buy shares directly, in whichever account suits you best.

I would also like a quick word about the perfect portfolio construction. In my view you should aim to hold a minimum of ten shares and an absolute maximum of 30.

As long as you spread these across different industry sectors rather than putting the whole lot, for instance, into gold miners, a number somewhere within this range will quite sufficiently diversify your risk. If you hold too many shares, you will simply find that you cannot monitor all of them.

A question that I am frequently asked is "how much should I invest in each share?" Bear in mind that you have to pay dealing commission of roughly £10 on each trade as well as a government tax called stamp duty of 0.5% on the value of every purchase (but not sale).

In addition to this we have the bid/offer spread, which is the difference between the price at which you can buy a share and the price at which you can sell it. Suppose then, that a share price is quoted at 99p-101p. To buy 1,000 shares would cost you, including all the broker's commission and stamp duty, £1,025. If you were to sell them a moment after, you would receive £990.

Make it worth your while

So the total costs of the trade amount to about 3.5% of the value. If you hold the shares for ten years, eventually selling them at £3, this is not a big deal. But if you buy one moment and sell the next, it becomes an issue. The longer you hold shares, and the less you trade, the less significant these dealing costs will become.

Another thing you must be aware of is that the £10 dealing commission is the same regardless of the size of your trade. If you buy £100 of shares, this £10 charge eats up 10% of your money. But if you invest £1,000, it only takes 1%. So the second way of minimising the impact of charges is to deal in large size. Taking these factors into account, I think that a sensible minimum for any trade is £1,000, and I certainly would not go below £500. You should look to build up a portfolio of at least ten shares, which is not to say that you need ten shares from the off. You can gradually build towards this number.

But I still have not answered that important question which shares to buy? That will have to wait until next week.

This article is taken from Tom Bulford's free twice-weekly small-cap investment email The Penny Sleuth. Sign up to The Penny Sleuth here.

Information in Penny Sleuth is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. Penny Sleuth is an unregulated product published by Fleet Street Publications Ltd.