Wishing You a Joyous Dussehra! Celebrate the victory of good decisions in your financial journey!
Build a Balanced Portfolio: Get 20% off on two or more services. | Avail Offer
Wishing You a Joyous Dussehra! Celebrate the victory of good decisions in your financial journey!
Build a Balanced Portfolio: Get 20% off on two or more services. | Avail Offer
SEBI Registered: Research Analyst | Investment Adviser | Call: +91 97730 15000 | Email: research@stockaxis.com
September 23, 2024
|For an individual investor, the virtue of patience is the single most important trait that he/she must cultivate when managing their own stock/securities portfolio. The volatility and uncertainty of the ever-changing markets can play spoilsport with an investor’s mindset and investment plans. Hence it becomes essential to chalk out a “plan of action” or “I will do “x” if “y” happens” kind of rule. While many investors are great at picking an investment strategy - few go down deeper and truly learn how to manage their portfolio with discipline and prudence.
In this article, we enumerate some ways in which you can better manage your portfolio. Consider it as a DIY- guide to portfolio management for an individual investor 😊
Diversification is one of the key tools investors use to minimize their downside risks in the market. Diversification is achieved by allocating different kinds of stocks across your portfolio—and you can mitigate potential losses from any single investment. Additionally, consider geographic and sector variations to further spread your exposure. This approach helps to stabilize returns and enhances the overall resilience of your portfolio against market fluctuations.
To effectively diversify one's portfolio, it’s important to understand the concept of correlation.
Correlation measures how closely different securities (like stocks) move in relation to each other. If two stocks have a high positive correlation, it means they tend to rise and fall together. In contrast, if two stocks have a low or negative correlation, they move independently. A well-diversified portfolio aims for low or negative correlation among its stocks. This means that if some stocks are performing poorly, others might still be doing well, helping to protect your overall investment.
In simple terms, diversification aims to create a mix of investments that do not all react the same way to market changes. This strategy helps minimize risk while maximizing potential returns.
While diversification is important, it’s also possible to over-diversify, which can lead to significant challenges, including:
Research states that the number comes in at 20.
In Edwin J. Elton and Martin J. Gruber’s book “Modern Portfolio Theory and Investment Analysis,” they concluded that with a portfolio of 20 stocks, the risk (as measured by standard deviation) was reduced to about 20 percent from ~50% when a portfolio larger than 20 stocks was made.
Therefore, the additional stocks from 20 to 1,000 only reduced the portfolio’s risk by about 0.8 percent, while the first 20 stocks reduced the portfolio’s risk by 29.2 percent.
Thus, the “marginal increase in the diversification benefit” does not increase significantly as the number of stocks in the portfolio increases upwards of 20 stocks.
Further analysis of diversification also considers a concept known as "covariance," which measures how much a set of stocks tends to move together.
As you decrease the number of stocks in your portfolio from 100 to 80 and lower, the covariance drops sharply.
However, this reduction in covariance levels off around the 20-stock mark, reinforcing the idea that 20 is often the most effective number for achieving optimal diversification benefits.
That said, it’s important to note that “20” is not a strict rule or a one-size-fits-all solution. In some situations, having more stocks can enhance the stability of your portfolio’s returns. As you add more stocks, the influence of any single stock on the overall portfolio diminishes.
Moreover, the greater the number of winners in your portfolio, the higher your potential returns will be. Certain stocks tend to massively outperform others over time, and these standout performers can come to represent a significant portion of your overall portfolio as time progresses.
The total amount you plan to invest also affects how many stocks you should include in your portfolio. For example:
Choosing the right allocation style is crucial and should reflect your individual risk appetite and investment goals. The two fundamental styles of allocation are:
One good example of tactical allocation is stockaxis’ MILARS® strategy. This strategy includes:
Another tactical investment approach is “Stocks on the Move,” which focuses on momentum-based factors to provide high-quality stock recommendations.
Position sizing is about deciding how much money to invest in each stock within your portfolio.
There are different schools of thought as to how to approach position sizing:
Equal-Weighted Portfolios: Some investors, like Mohnish Pabrai, prefer to allocate equal amounts of money to each stock. This is often best for those with a long-term investment perspective.
Statistical Approaches: Others may use statistical metrics—like volatility, or risk ratios like the Sharpe, Treynor, or Sortino Ratios—to decide how much to invest in each stock.
Back-of-the-envelope calculations: Some investors also make use of back-of-the-envelope calculations to determine the position sizes. As long as one is aware of the level of risk being taken, we are good to go.
Position sizing is primarily about protecting your capital rather than just trying to maximize returns. It focuses on how much risk you’re willing to take with each investment.
“Over-diversification is a hedge for ignorance”
“Observation, experience, memory, and mathematics - these are what the successful investor must depend on.”