Friday, February 24, 2012

Criteria for Portfolio Construction

I was seeing fundamental reports on Ranbaxy from two brokerage houses on the same day – one a buy report, and another a sell report.  It’s natural to ask who is right between the two? Well, it depends.
I get queries on portfolio advice from fellow investors – whether a particular stock is a buy or sell, how much weight it can be allocated in the portfolio, how many stocks to have and so on. I wonder how can you give any meaningful advice without knowing the investor’s profile, goals, time horizon and his/her risk taking ability.

The point is stocks are held by investors for different reasons. There cannot be any one-size-fits-all approach when it comes to portfolio construction. Come on.. you may buy a pair of shoes from the best brand and company, but of what use if that’s not your size. Equity portfolio is not the same but customization to your fit is definitely necessary.
Let’s look at the key criteria that I find useful to gather information on before giving any portfolio level advice to an investor.
1.       Time horizon – Number of years (or months) one would be comfortable holding a stock. Somebody said “forever”. Well there are very few stocks of the evergreen kind. Even if there are, that call has to be taken with successive reviews, not at one shot for rest of your life. Markets are too dynamic to make such a judgment.
2.       Individual profile – This covers investor’s age, background, number of dependents, lifecycle stage, nature of employment, whether pensionable job, current networth and asset allocation.
3.       Investment goals – Important questions to ask are – while investing in stocks are you primarily looking at capital appreciation alone or for steady dividend income? Is retirement planning one of the objectives when you buy equities as a long term strategy?
4.      Return expectation – G-sec or Bank FD rate + x% that you’d like to earn for the risk that you wish to take when investing in equities. How much is this x%? One can’t beat the market every single year. Realistic return expectation can hold an investor in good stead over a period of time.
5.       Risk appetite – To put it simply, can you take in your stride part or full loss of capital invested in a stock. I’m not saying that will happen to you, but as part of mental make-up, are you financially prepared if markets or stocks held don’t go the way you want them to be for sufficiently long time. It can happen for various reasons and seasons.
6.       Equity weightage – What percentage of your networth is already in equities and in financial assets? And what percentage of your networth would you like to be in equities?
7.       Concentrated vs Diversified – Hold a concentrated portfolio of 3-4 stocks or diversify to 15-20 stocks or build a MF type portfolio of 30-40 stocks. This debate is a bigger issue and may deserve a separate post. For the time being, suffice to say depends on the investor profile.
8.       Risk tolerance – Can you sleep well if one of your large positions is down by 20-25%?  In equities, volatility is a given, and if every fall worries you then the low beta portfolio needs to be crafted accordingly.
9.       Family needs - Number of years you won’t need to dip into equities without compromising your family goals and personal needs that are not deferrable (like planning for a house, kid’s higher education, marriage etc).
10.   Investing skills - One’s basic skills as an investor in terms of behavioural patterns and educational background in finance.
11.   DIY - Last but not the least, if you’re going to be DIY Type (Do-It-Yourself) investor, better to assess upfront how much time you can devote to researching companies & stocks. I mean can you give say 8-10 hours per week or more. If not, active portfolio management may be a difficult ask, and one may need help from an expert or some professional advice.
To elaborate, you may get a tip from a reliable source or service on buying a stock XYZ in February 2012. Now with fundamental changes in company’s fortune you don’t know whether it’s still a hold in 2014, or you should have dumped it in the first year itself when the initial investment thesis went wrong. Sound grounding in criteria for portfolio construction is helpful in understanding such situations.

1 comment:

  1. Nice post,keep posting on how to follow the above mentioned principles in day to day during stock picking whether to build portfolio based on low beta stocks or to have mix of both low and high beta stocks in a diversified portfolio to begin with during initial stages of stock picking