The Importance Of Anchor Stocks
At 26, I'm unused to my mother asking me for advice, but that’s exactly what happened recently when she approached me about opening a brokerage account. Having reassured her that you can never be too old to start investing — perhaps we can cover this topic in a future insight — I posed to her the most important questions she needed to ask herself before making her first investment:
What is her risk tolerance?
What is her long-term goal?
Is there a company she really loves and believes in?
How does the company’s balance sheet look?
What is its historical performance?
Does it pay a dividend?
Does it have a moat?
Most importantly for a first-time investor, I asked her to identify her 'anchor stock' — a company she loves and understands better than any other. I believe that this should be the first investment you make because it is one you’ll be proud to hold on to forever, it can weather economic downturns, and you can build your entire portfolio around it.
Here are the characteristics of an anchor stock:
It’s a stock you will continue to top up forever and never sell.
It is usually a large or mega-cap stock such as Amazon (AMZN) or Berkshire Hathaway (BRK.B), meaning that its stock price movement is not volatile, quite literally ‘anchoring’ your portfolio.
It pays or has the potential to pay strong dividends, which in turn can be reinvested into your portfolio or used as income later in your investing life.
It’s a stock that represents the largest portion of your portfolio.
Some of you may already have anchor stocks and not even be aware of it, but it’s important to identify one that you can rely upon with a long-term plan in mind for a number of reasons:
By building a strong core in your portfolio, it allows you to assess your own tolerance for risk. If you are an investor who likes to ‘put it all on red’ with a number of high risk, high reward investments, then an anchor is a great way of mitigating against the downsides of these risks.
For every investment in the likes of Trupanion (TRUP), Beyond Meat (BYND), or Virgin Galactic (SPCE), you should also be investing as much — if not more — in your anchor stocks. This can minimize the damage in case these riskier businesses fall on hard times, as well as diversify your portfolio. This way, should the market enter a volatile stage as it did in March, when those riskier stocks begin flashing red, your less volatile ‘anchors’ will keep your portfolio from plummeting.
Although it might sound counterintuitive to a risky strategy, it will actually give you a strong base from which you are able to invest in riskier endeavors, knowing that your anchor can act as a safety-net of sorts for that behavior.
Another important piece of information you can glean from your anchor is whether it will help you achieve your long-term financial goals. It is no harm to have one or more anchor stocks who have already had long-term, consistent annual growth and see how it lines up with your own plan.
For example, a strong anchor stock might be Microsoft (MSFT), which has a CAGR of 7.7% over 5 years. Though it is not assured, if 25% of your entire portfolio is made up of Microsoft stock, then you can plan that a quarter of your portfolio is expected to grow by 7.7% per year and manage your other investments around that. Of course, we all know that there’s no point in attempting to predict the stock market, which is why a dollar-cost averaging strategy is a great way to get the most out of your anchor stock.
If you’re not familiar with this concept, I’d highly recommend reading our post on its uses as an investment strategy.
A great anchor will also provide dividend payments, such as Microsoft, which currently pays out $0.51 per share every quarter in dividends. If you own a sizable chunk of stock then this is income which you can reinvest into the rest of your portfolio, or even better, if your position becomes large enough, it might serve as a source of income when you retire.
My own anchor stock is the first stock I ever invested in, which currently makes up one-third of my entire portfolio: Apple (AAPL). I love the company, it shows consistent growth, it’s a mega-cap business with little stock price volatility, it pays dividends, and I’m never going to sell it.
As for my mother, I’m pretty sure she’s just going to invest in Google (GOOG), which isn’t a bad choice at all.