How to Form a Stock Portfolio

Stocks are usually a core component of investment portfolios because they offer capital appreciation and dividend income. The design of your stock portfolio is important because its performance could affect your financial plans. The design will depend on your financial objectives, short- and long-term cash flow needs and your willingness to tolerate volatility. Successful investors buy a handful of stocks, focus on companies they understand and make buy-sell decisions based on the fundamentals.

Prepare a list of companies that you know and understand. For example, if you work in construction, you could prepare a list of homebuilders and building materials suppliers. Similarly, if you understand the retail sector, you could list department stores, specialty retailers, food service companies and related suppliers. You can always diversify your stock portfolio using mutual funds that invest in specific sectors, such as technology and energy.

Trim your list because you can't monitor dozens of stocks. Remove companies that do not have a healthy balance sheet, including a high level of liquid assets relative to short-term liabilities. Keep companies that have demonstrated steady quarter-over-quarter revenue and earnings growth. Avoid companies that have frequent senior management turnover because that creates strategic confusion and operational uncertainty. You will find most of the relevant information in quarterly and annual reports posted on the investor relations sections of corporate websites.

Set entry and exit price targets for each stock in your portfolio. Use financial ratios, such as the price-to-earnings ratio, to set these targets. The PE ratio is the ratio of price to trailing 12-month earnings. You might want to accumulate shares in a company when it is trading at or below its historical PE ratio. Conversely, you might want to take profits if a company's PE ratio is significantly higher than the historical average or that of its industry peer group.

Monitor and rebalance your stock portfolio periodically. Monitoring involves reviewing quarterly financial reports and exiting positions in companies showing signs of weakness. These signs could include missed earnings estimates, failure to launch products on time and increasing competitive pressures. Rebalancing could involve reducing positions in stocks that have had strong recent rallies and increasing positions in undervalued stocks.