Most of us find the idea of selecting a set of stocks to build our equity portfolios for our long term financial goals quite enticing. And understandably so, given the kind of excitement most of us associate with researching and curating various stocks to include in our portfolios. But more often than not, we pick stocks for our portfolios at random without a clear framework in place which serves as a guide to pick, hold and sell stocks in light of our needs and risk profiles. As a result of this, we fail to construct stock portfolios effectively. This can be quite dangerous, especially if we are building a stock portfolio as part of a goal based approach to investing and financial planning. Therefore, today’s post will be focused on considerations that need to be made before building a stock portfolio, so that we build effective stock portfolios that are optimally aligned to our risk profiles and financial goals.
The exercise of building a stock portfolio begins with arriving at an asset allocation strategy for each of our financial goals and risk profiles. I am of the opinion that the equity allocation for any particular long term goal should not exceed 60-70% of the portfolio designed for the goal, regardless of our risk profiles. Therefore those of us who do not have a clear understanding of our risk profiles can begin with minimal exposure to equity and gradually build overall equity exposure to not more than 60% of the overall portfolio designed for the goal. The same holds true for those who have a conservative or moderately aggressive risk profile. Those with a slightly more aggressive risk profile may consider the option pushing this limit to not more than 70% of the portfolio.
Deciding the overall orientation of the portfolio would be the next step. A portfolio's orientation basically represents the approach with which it is built. Some of us may choose to build equity portfolios that are completely oriented towards stocks of high quality, well established bellwether companies (technically called large cap stocks). Some may choose to build portfolios entirely with stocks of companies that are relatively smaller or very small compared to bellwether companies (technically called mid cap and small cap stocks). Others may choose to build a portfolio with a balanced combination of all three categories of stocks. To my common sense, the best way to build an equity portfolio would be to stick solely to bellwether stocks within a major market index such as the Sensex, Nifty 50, Dow Jones Industrial Average and so on. Such an approach would increase our likelihood of us being able to enjoy the benefits of both capital appreciation as well as dividend receipts from our stocks. And the fact that bellwether stocks are usually not as volatile as mid cap and small cap stocks would make it easier for us to stick to our portfolios for long periods of time without being emotionally affected by significant degrees of volatility. The number of stocks to be included in the portfolio is another important consideration that needs to be made. Contrary to popular perception, it makes very little sense to build portfolios with 15, 20 or more stocks. For all practical purposes, a portfolio built with a set of 8 to 10 stocks which are diversified across a variety of sectors and businesses is more than sufficient to deliver optimal long term returns.
Once the orientation of the portfolio has been settled upon it would be time to focus on stock selection. When selecting stocks for our portfolios, we must ensure that we achieve diversification at two different levels. Firstly, we must ensure that our portfolios give us exposure to various types of stocks. Some stocks may represent companies whose future growth prospects are bright, thereby providing the benefit of rapid growth of the amount invested in the stock. Other stocks may represent companies that pay dividends regularly. Some stocks are relatively less volatile in nature and hence serve as a defense mechanism for portfolios during downturns. Therefore it is important that we gain exposure to as many types of stocks as possible, so that we can derive a wide variety of benefits from our stocks.
Therefore, we must orient our portfolios to give us exposure to various sectors and industries in the economy. This would ensure that the overall risk of our equity portfolios would be optimised. The best way to diversify portfolios across sectors would be to look at the various sectors within a major market index and purchase the stock of the company that is the market leader within each sector. The quality of the stock and underlying company must carry more weight than the cost of the stock when deciding which stocks to pick and include in our portfolios. Adopting such an approach would mean that an 8 to 10 stock portfolio would give us exposure to an equivalent number of sectors, thereby ensuring adequate sectoral diversification. An example of the sectoral composition of a sample portfolio is given in the graphic that follows.
Having a clear idea of the circumstances under which we want to sell our stocks is just as important to the process of building a stock portfolio as stock selection. Therefore we must define a clear set of criteria under which we would sell our stocks. The reasons or criteria for selling could vary from having achieved a certain rate of return from the stock, deterioration in the fundamentals of the company underlying the stock, regulatory restrictions and so on. What is important is that if the set criteria is triggered at any point of time, we must push through on our plans and sell regardless of other factors.
Stock portfolios that are left untouched after they are built invariably get lopsided and go out of balance over a period of time. This would hit portfolio returns adversely over a period of time. Therefore it is vitally important to rebalance our stock portfolios at regular intervals. These intervals may be defined in terms of time periods (annually or semi annually for instance) or deviation in portfolio weights (rebalancing when the weight of a particular stock or sector in the portfolio deviates by a set percentage). Regular rebalancing reduces risk at the portfolio level by ensuring that portfolios do not suffer a drastic drop in value in the event of a prolonged downturn or sudden crash in the markets. This helps ensure that portfolios deliver returns that are optimal, stable and sustained.
Quite clearly, there is a lot more to building stock portfolios than just picking a set of stocks that capture our imagination. The exercise must be carried out within the confines of a clear framework as discussed above. Risk management and optimisation must be prioritised over return maximisation. We may pick the best stocks possible for our portfolios, but that never proves to be the decisive factor as to the effectiveness of our portfolios. What ultimately decides the success and effectiveness of a portfolio is the prudence with which it is built, the consistency in the way it is operated and the discipline with which the underlying principles put in place by us as investors when building the portfolio are stuck to. Adherence to such an approach would ensure that our stock portfolios stack up very well and in all probability achieve the purposes for which they have been set up.
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