Most of us aspire to have some investment in stocks (direct equity), and generally start investing in stocks based on guidance from friends, ideas from some TV News channels, and by reading blogs on www.moneycontrol.com and other such financial web sites. Also, some people like to invest in hot stocks which are discussed on TV news channels, and also by having discussions with your friends in office where you work. While all this helps us to start our investments in stocks, there is no guidance available from these sources on how to maintain a portfolio of stocks, when to buy the stocks and when to sell the stocks.
There are ample examples around me, where people start investing with just 4-5 stocks since they have less sum to invest which is all right to begin with but when your investment amount slowly becomes larger and cross certain threshold, then protecting capital and minimizing risk becomes equally important apart from growing money at 20% CAGR or more.
This article discusses the importance of a Diversified Equity Portfolio.
The classic definition of Diversified Portfolio is - Investing in different asset classes and in securities of many issuers in an attempt to reduce overall investment risk and to avoid damaging a portfolio's performance by the poor performance of a single security, industry, (or country).
Picture: Diversified Portfolio Example
Note that, I am not saying that, this is the only strategy which is correct or the best, but for a beginner having less knowledge of a particular company or business, and who is new to investing in stocks, it is always a good idea to start with a Diversified Portfolio which minimizes your risk to some extent.
Sometimes people get carried away by the recent performance of the stock which might have given them over 150% returns in past one year, and they will continue holding it even it is overvalued or extremely overvalued. After this, there is one bad quarter for that company, and they see the stock price correct by about 30% or even more, and some of their profits are wiped out in few days. If you have a portfolio of just 5-6 stocks, then this can adversely affect your returns. I am not saying that, you should not have Concentrated Portfolio but I am just highlighting some of the risks in having Concentrated Portfolio if you have not done enough research on those companies and have invested your hard-earned money on ideas borrowed from your friends.
Hence thumb rule in Diversified style of investing is - keep a diversified portfolio of about 15-20 stocks, and based on conviction you can invest 3% to 6% in one story (one stock), but generally cap the max % of one stock in the portfolio to 12% ideally in such case. Such diversified portfolio also has another advantage. You can start position with just 2% also, and that becomes 9%-10% in few years if it generates 400% returns ahead of other stocks. If the price is slightly high than your comfort zone or conviction is less, you have liberty to start position with just 2%-3% as well, and if it performs better ahead of your expectations, position becomes big. Concentrated portfolio on the other hand may not allow you to take such small position.
How to construct a Diversified Portfolio?
One of the rules in having a diversified portfolio is, you should decide how much % of money you would be comfortable in investing in one sector. Some of the experts advise to cap this to about 30%, that means, you should not have more than this % in one sector, Say IT sector. Once you set this percentage, then you can distribute this across 4-5 stock ideas, which results in having about 5% to 6% allocated to one stock idea. You can use your research and conviction to decide whether you want to start with 2%-3% and gradually increase to 5% or more, of you can start the position with 5% to 6% at one go. Again, this percentage is based on your conviction level in that idea. I know that, many investors are comfortable in allocating up to 8% if their conviction in that stock idea is high. This is perfectly fine as long as you the business well. Most of the time, your understanding of the business improves after you hold that stock for few years. If you work in BFSI sector, you may have an excellent understanding of that sector and you can leverage upon that understanding.
So, now let us assume that, you have identified 4 sectors which you would like to invest in as Banking, IT, FMCG and Engineering. Now, you can start identifying stocks from each sector, and start adding those to your portfolio.
How to maintain a Diversified Portfolio?
The next step, is to monitor your portfolio on quarterly basis. After every quarterly result, the stock price sometimes moves up or down depending on the performance of the company. That gives you an opportunity to either buy more of the stock, hold onto the stock, or sell the stock.
Not only this, but Market swings in various directions based on global events, RBI policies and other government policies from time to time, which gives you an opportunity to buy/hold/sell stocks.
Idea here is not to buy/sell stocks after every quarterly result but I am suggesting how quarterly result is one of the important event for taking decision about your portfolio. If you are having the stock as a Long-Term Growth story, then these quarterly results only will confirm whether growth story is intact or not, and mostly you may have to simply hold the stock. Once you buy a great stock at optimum price, you have to simply hold it tight for a very long duration to see your position grow in the portfolio.
Following are some of the ideas to maintain this Diversified Portfolio:
1. Diversify across 4-5 sectors (at least 2 sectors could be defensive – Pharma, FMCG)
2. As far as possible, aim to replace the stock in a particular sector by another opportunity in the same sector (After selling a Banking stock, aim to add/buy another stock from BFSI sector)
3. If rule 2 is not followed, Portfolio gets skewed towards particular sector (e.g. IT/Pharma)
4. Ensure that, weight for one sector do not exceed > 30% (Morning star philosophy)
5. Portfolio Balancing is important to generate consistent 15-20% CAGR or more – Sell overvalued stocks if required to reduce its weight to the set threshold
6. In a 15-20 stock portfolio, ensure that single stock should not exceed 1.75 times to 3 times average allocation of 5%-6%
7. Total number of SELL cases should be max. 6-7 per year and BUY cases should be max. 6-7 per year, with 2-3 years perspective of holding. (This is not necessarily the case if you are going to hold the stock for 8-10 years depending on the performance of the underlying business but a suggestion).
There are multiple portfolio strategies like Concentrated portfolio, Diversified Portfolio, and mixed of the both and you must have a process in place and should stick to that process to achieve consistent returns. Here, in this article, I have discussed about Diversified Equity Portfolio as one of the equity portfolio strategy.
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