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Portfolio Construction

by Altais on January 13th, 2013

Constructing the right asset portfolio is one of the most important part of investments, perhaps more than or equal to deciding where to actually invest in. The options are plenty – from cash under mattress to fixed deposits to equities to real estate to gold to commodities to art etc. It’s a very personal choice with only one rule, Invest in what you understand well. It’s not a fixed template as most financial planners pronounce. My thoughts on it have evolved over a period of time, and am pretty sure will continue to evolve further with experiences, learnings and lessons.

First, I am a one trick pony, with all my net worth in equities (or cash meant to be deployed in equities), save ancestral property or wife’s jewellery! So I can’t really comment on most asset classes other than equities. Second, I consider only debt, equities and real estate as bona fide asset classes, and rest as speculative or too hard to predict for me.

So, the key questions that we will focus on are:

1. Equity as a part of Net Worth

Of course, it’s a very individual preference but people have very strange formulas.

Equity as part of Net Worth should be (100 – Age).

What about your knowledge about equities, availability of right investment options or the fact that with age, your knowledge about equities will only increase and this is an area where knowledge snowballs?!

I will invest 20% of my net worth or 1 year salary into Equities, speculate with that and Invest balance in safe FDs.

Why can’t you invest the whole amount in moderate gain Equities? Suppose you are successful in speculating, and you earn 50% return on that 20% allocation, and earn post tax 6% on balance 80%, cumulative return will still be only 14.8%, and that is assuming you are right about getting 50% on your equity portfolio every year. Targeting moderate 20% on your entire or majority of your net worth over the long term would be far better. There have been many high quality businesses like ITC, Asian Paints, HDFC Bank, HDFC, Hero Honda, CRISIL which have given these kinds of returns in the past. Of course, you need to study current outlook and valuations before investing for future.

The real determinant of equity allocation should be:

a. Your knowledge about equities (and whether tested by time and vagaries of the stock market)

b. How much time you are willing to commit to this task

c. Your financial net worth – whether financially independent or with laden with high/ uncertain liabilities

d. Correlation of income/ savings with stock markets, in case you are from fund management background/ full time investor

e. Expected Income and Expenses over the short/ medium / long term

f.  Availability of Right opportunities in the market

My personal preference is to invest fully into equities given the right opportunity/ keep cash to invest into equities when the right opportunity comes. Of course, this calls for some safety nets, which I would talk about in a while.

2. Individual stock allocation in Equity Portfolio

People run various type of portfolios – from very concentrated (1 stock!) to very diversified (some stock at 1% of portfolio!!).

Well, this is less strange than the above examples, as there are different equity strategies which people employ. If you buy cigar butts, you have to be diversified. If you buy big moat businesses at reasonable/ cheap valuations, you can be very concentrated. (See for a very intelligent discussion on this).

My personal preference is to be moderately concentrated – around 8 stocks with minimum allocation at 10% and maximum at 30%.

The size of the bet depends on the following factors:

  1. Quality of Business
  2. Margin of Safety/ Upside Potential
  3. Presence of Catalyst
  4. Cash in Portfolio/ expected cash inflow
  5. Alternative Investment Options
  6. Overall Market Valuations

Lot of factors to check :) Actually, implementing it is pretty simple.

These factors also play an important role given the first condition – being 100% in Equities and running a moderately concentrated portfolio. I can’t speculate – either by way of quality of business or by way of valuations. I can’t invest in companies which make my stomach churn, or valuations which make my head spin. I might miss lot of opportunities, and then one can always count on Mr. Market to offer another opportunity.

To quote Warren Buffett, “In investments, there’s no such thing as a called strike. You can stand there at the plate and the pitcher can throw the ball right down the middle, and if it’s General Motors at $47 and you don’t know enough to decide General Motors at $47, you let it go right on by and no one’s going to call a strike. The only way you can have a strike is to swing and miss.”

As it is, we will make some mistakes in investing; we don’t need to compound it further by forced swinging. After all, all we need are a couple of investments a year.

A quick word on how a typical investor’s asset portfolio analysis evolves (from direct and vicarious experiences):

a. When we start investing, we just focus on how much money we can make on a particular stock.

b. Then as we gain some experience, we start looking at how much we can lose in a particular stock before thinking of gains.

c. As we encounter value traps, we start calculating Expected Return : estimated profit on a particular investment * probability of return within definite time frame.

d. Then we come across growth traps, companies where earnings keep increasing but stock remains stagnant due to initial high valuations. We start thinking about how much growth is already priced into stock price.

e. Then we start looking at correlated risks across the portfolio

f. We stop indulging in mental mathematics – calculating current dividend yield on historical portfolio value, selling half of a stock which has doubled and treating balance as free, netting off profits from investment value to lower our “holding cost”. We start looking at potential risk and returns of our portfolio at current market value.

g. Finally, we start evaluating the impact of the potential portfolio increase or decrease on our net worth. That’s where it hits the hardest.

Maybe there a few more stages to cover?!

So, the actual equation becomes something like this:

Happy Investing!

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