Thumb Rules for Equity Portfolio Design

Diversification: Half of portfolio design theory can be summed by this one word. Indeed, a large part of risk management could be achieved simply through diversification. However, we see that this rule is violated by a large number of investors. Some commentators have advocated more concentrated portfolios as a way of “beating” the market. However, we believe that concentrated portfolios are appropriate only for a very small set of sophisticated, professional investors who are able to incorporate other risk management tools and are constantly monitoring their portfolios.

We summarize below a few thumb rules that we use. These are meant to be guiding principles and are not cast in stone. Any number of combinations are possible and an investor should choose a combination that best reflects his/her risk appetite.

• Number of stocks: Generally, the more the merrier, as diversification is important. However, a higher number of stocks needs to be weighed against the ability of an investor to track the fundamentals of the company, quarterly results, valuation changes, outlook for business etc. We believe that 25-35 stocks in a portfolio is the sweet spot. Ideally, a portfolio should not have less than 20 stocks (diversified across industries). The marginal benefits of diversification reduce as the total number of stocks in a portfolio exceeds 40.

• Stock weightage/concentration:Ideally, a single stock weightage in a portfolio should be 3-6%. Anything higher than 7% in a single stock would expose the investor to elevated risk in that stock. It would be prudent for an investor to rebalance a portfolio if single stock exposure becomes much higher than the above range. This will also result in forcible taking out some profits which otherwise becomes difficult if the stock seems to be doing well.

• Tail Stocks:Tail stocks are stocks which are less than 1% of the portfolio. Investors often have a large number of tail stocks. The performance of a stock with 0.2% or 0.3% weight in the portfolio would not meaningfully impact the overall portfolio returns even if the stock were to double. Another reason for existence of large number of tails stocks is some stocks have suffered significant losses and become penny stocks. They largely sit there as the investor hopes that they will bounce back. Such stocks should be exited and funds raised should be invested in better companies to save further capital erosion. You should certainly consult your tax consultant to see if capital tax losses would be available on such investments.

• Sector Concentration: Ideally, a portfolio should have a minimum of 8-10 different sectors with no single sector being more than 20%. However, Banking, Financial Services and Insurance (BFSI) may have a higher weight in the portfolio given that BFSI has a weight of around 35% in the Nifty.

• Market cap weightage/ concentration: This should be a conscious decision taken by the investor depending on his risk appetite. A conservative investor might have say a 70:15:15 allocation to large, mid and small cap stocks while a more aggressive investor may even have a 40:30:30 allocation to large, mid an small cap stocks. Any number of such combinations are possible. Ideally, an investor should define his personal target allocation. Investing in and monitoring small and mid-cap stocks requires far greater research as compared to larger stocks because they are not widely covered and material developments in such stocks often slip under the radar.

• Sector Overweight and Underweight: Professional fund managers generally monitor sector overweight and underweight decisions and make a deliberate, conscious choice in allocating sector weights. Most investors, however are not even aware of the sector weights of their portfolios. Generally, investors show a significant familiarity bias in their portfolio allocation. Sectors in which they are working or have familiarity otherwise, have a very large share/overweight in their portfolios. The sector weights of Nifty50 or BSE500 could be used as a benchmark while deciding the sector weights for a portfolio.

• Greed: Quite often we see investors investing 15-20% of their portfolio in a single stock. This is often driven by a belief that the stock would give significantly superior returns compared to the market. This belief may be driven by bottom up research or some “hot” stock tip or a stock which is displaying momentum. Even in such cases, investors should follow the thumb rule of maximum 7% exposure to a single stock. After all, the above rules are meant to prevent catastrophic losses from greed. Also penny stocks need to be avoided even if there is a lot of buzz in the market about the stock.

• Portfolio review: Ideally, investors should review all their portfolio stocks constantly for material price/ business developments. Quite often this may not be possible. Investors should review their portfolios at least once a quarter. We believe that investors would benefit by seeking help from experienced professionals in reviewing their portfolios.

Summary:

In the section below, we suggest a simple portfolio design which are meant as an illustration of the principles discussed in the earlier section:

• Illustrative portfolio A: 25 stock portfolio with each stock having a portfolio weight of 3-5% and diversified across 6-8 sectors.

• Illustrative portfolio B: A 30 stock portfolio with 10 stocks of 4% weight each and 20 stocks of 3% weight each. The stocks should be diversified across 8-10 sectors.

• Illustrative portfolio C: A 35 stock portfolio with 10 stocks of 4% weight each, 10 stocks of 3% weight each and 15 stocks of 2% weight each. The stocks should be diversified across 8-10 sectors.

Number of stocks, sectors and weights can change depending on risk appetite of investors and the time and skill that he possesses to monitor stocks.

As discussed earlier in the note, the above rules are meant only as guiding principles which ensure diversification in the portfolio, reduce risks in a portfolio and reduce volatility. A large number of variations are possible within the above design parameters. An investor should select the design based on his preferences and risk appetite.

The rules summarized above are largely about being smart in risk management. A lot of equity investors have a poor historical experience in equity markets. This is mainly driven by poor risk management. We believe that investors can improve their long term returns by following the above thumb rules described.