How to construct stock portfolio ?
Guidance to construct stock portfolio
Successful Investing is not only about picking right stocks but also it requires proper portfolio allocation. Normally it seems very easy to construct stock portfolio,but proper portfolio allocation is one of the most complex part of successful investing. During the last few years, I had reviewed portfolio of several investors and noticed that 90% of those portfolios are very poorly constructed. 85% retail investors suffer loss not because of poor stock selection but because of poor portfolio construction. Still proper portfolio construction is one of the most ignored subject in investing. You may also noticed that in spite of few great performers in your portfolio,you are in overall loss. Just few days back I was evaluating a portfolio of one of my clients. There were 4 stocks in his portfolio showing 200%-300% profit but still his portfolio is in overall loss!! This is quite surprising. The only reason of such negative performance is “Over-diversification”
Every financial planner will suggest you to diversify your portfolio. I am also saying the same. The problem is 85% small investors does not know the proper meaning of diversification and how exactly it can be achieved. There is a slight difference between diversification and over-diversification. While diversification can help you to create wealth systematically at the same time over-diversification can easily destruct your hard-earned money.Every financial planner will suggest you to diversify your stock portfolio but majority of them don’t guide to construct stock portfolio applying proper diversification.
In this article, my focus will be on how to construct stock portfolio systematically to maximize return.
Know the exact meaning of “Diversification”
Diversification does not necessarily mean having a huge number of stocks in your portfolio. Investors often construct stock portfolio with 40-50 stocks (or more than that) to diversify their portfolio. If you are one of them then you are committing a great mistake at the very beginning. A portfolio of 80 stocks may not be properly diversified where as a portfolio of only 10 stocks may be properly diversified. Let’s take an example to clarify this statement. In the following example I am considering two stock portfolio with the following stocks-
- Portfolio 1 (23 Stocks) :- HDFC bank,ICICI bank,Axis Bank, State Bank of India, Bank of Baroda,PNB, ITC, Hindustan Unilever, Marico, Dabur, Colgate,Emami,Britannia, Tata Motors, Maruti Suzuki, Ashok Leyland, M&M,Bajaj Auto, DLF, Unitech, Sobha Developers,Oberoi Realty.
- Portfolio 2 (10 stocks) :- HDFC bank, ITC, Sun Pharma, Maruti Suzuki, Oberoi Realty, L&T, Reliance Industries,TCS, Tata Steel,Bharti Airtel.
Have a close look on both the portfolio. First one have 23 stocks and the second portfolio have only 10 stocks. Now tell me which one is more diversified?
First portfolio has 23 stocks but all those are from 4 different sectors(banking,FMCG,Auto and realty). Second Portfolio has only 10 stocks but from 10 different well-known sectors.So, obviously the second portfolio is more diversified.
In any economic downturn 1st portfolio will be affected the most. Banking,auto and realty all those 3 sectors will hurt first in economic slowdown and majority of “Portfolio 1 ” stocks are from those sectors. At the same time second portfolio won’t be affected much as there are 10 different sectorial stocks. It is unlikely that all those 10 sectors affect at a single time. Even if you follow any bear market you will find few sectors always outperform others.
Problems with huge number of Portfolio Stocks:-
Some investors take pride having 60+ stocks in their portfolio. If you are one of them then follow associated problems to hold such large number of stocks-
- Very difficult to track properly :- Whether you are following any expert’s advice or not,it is very essential to track all of your portfolio stocks at regular interval, at least once in a week. Tracking does not mean just to check stock price. You should follow (at least) the quarterly result,all company related news, competitors status and management interview.You must have to devote 30 minutes per week on an individual stock. Now if you have 60 stocks in your portfolio,it requires 1800 minutes or 30 hours per week. So, around 4 and half hours per day. Now for a working individual,it is not possible to devote 4 and half hours daily after completing his full-time job. This is why I simply hate 30+ stocks in any stock portfolio.
- Negatively affect your overall return :- Suppose you have 60+ stocks in your portfolio.Out of them if 4-5 stocks generate 100%+ annualized return then also your overall return may not look bright. Negative/Flat return from other poor quality stocks may minimize the gain. Always remember,the number of high quality stocks are always much lesser than the poor qualities stock. Out of 7,000 listed companies in India less than 0.5% stocks generate 100%+ annualized return(multibagger) ,5%-10% stocks generate 20%+ annualized return,another 10%-15% generate 10%+ return, the rest 70-75% stocks either remain flat or generate negative return. Now,think about it how difficult is to pick multibagger stocks and how easy to select poor quality stocks(deliver negative return). So,if you have 60+ stocks in your portfolio then there is a very high probability that 50% of those companies have poor fundamentals.(Generate negative/flat return).
World’s most successful investor Mr. Warren Buffet (second richest person in the world) always prefered to keep 10-15 stocks in his portfolio. In spite of having 40-42 stocks, Mr. Rakesh Jhunjhunwala (Indian billionaire investor) restricted 90% of his holdings into 10-12 stocks. So, why should you construct stock portfolio with huge number of stocks? Why are you looking for new names frequently?(I had received several mails from my members asking for such new stocks,which are not even part of his existing portfolio)
Limited in Numbers but diversified across sectors:-
Proper diversified portfolio must contain limited number of stocks but diversified across sectors. One of my client once told me that nobody can suffer loss if he construct stock portfolio only with Pharma and FMCG stocks. If you also believe in such theory,then immediately change your mind. Such concept can easily destroy your wealth over long run. Actually, during the last 5-6 years FMCG and Pharma companies dominated the market and generated above average return. The picture was not same 10-15 years ago. My point is a single sector can’t dominate for long.I am taking an example from our popular sports,Cricket. During 1970-1985 West Indies dominated the world Cricket,today they are nowhere. During the last decade and a half Australia was No.1 cricket team in the world. Now the baton is already shifted (or shifting) towards India. This is also obvious that in future another country will emerge as No.1 team. So,there is no permanent winner. Similarly in the stock market the best performing sector of the last year can easily become the worst performer. So,just memorize this single point – “Proper diversified portfolio must have limited number of stocks but diversified across sectors.”
Task is not over- Timing and Percentage allocation is the most vital part :-
So, I think now you don’t have any doubts regarding the number of stocks that should be part of your portfolio.Let’s move towards the another two most important consideration to construct stock portfolio ; “Timing” and “Percentage Allocation”. Always remember, if your timing is wrong then you can earn negative return from the world’s best company. Take the example of State Bank of India. SBI is one of the most well-known blue-chip stock. If you invested in SBI during November,2010,then today after 3 years you are still in 40%-50% loss.!! Similarly,you can earn great return from medium quality stocks if you purchase it at right time. Consider SKS microfinance. The company is not so strong,still it offered great return those who invested in the crisis time. Another important consideration is percentage allocation of individual stocks. If a single stock (even if it is the world’s best company) occupy more than 40% of your portfolio value,then you are in risk. I have seen such risky allocation in several portfolio. I had noticed that more than 70% investors doesn’t have any clue of Proper Percentage allocation. That is another major catalyst of any loss-making portfolio. The most disappointing part is to notice the best performing stock has the least percentage allocation in your portfolio. Similarly,your portfolio can be wiped out if the worst performing stock occupy the major portion of your portfolio. I am sure there will be many readers who are victim of such occurrence.
Bad News:- “Timing” and “Proper Percentage Allocation” are two such subjects that you can’t learn in a single day.(Even if I write 100 articles on this). Experience,huge devotion and also huge knowledge are required to master those things. Actually there are several variables attached with it. Market is ever-changing so not a single formula is applicable in every condition. You have to be alert all the time. You have to accept your mistakes and learn from it.
To reduce such hectic burden of proper portfolio construction, we have introduced “Monthly Portfolio Allocation Guidance” where you can get clear idea about “Timing” and “Percentage allocation”. If you have monthly investment habit then this model will be best for you.It is also very easy to follow.Each and every month we allocate a predefined amount into various stocks, replicating which you can also build your solid long term portfolio. Click here to know more about “Monthly Portfolio Allocation Guidance”.