Portfolio sizing is the key to portfolio return
If a portfolio is not created with the right size, capturing a good investment may not have any meaningful impact on the portfolio.
Newbie investors often brag about the high return they made on the stock. If you deep dive, the portfolio allocation is usually so small that it almost immaterializes the portfolio return.
A mature investor carefully considers the mispricing and allocates substantial capital if the odds favor him. This way, when the gap between fair value and the current price reduces, the investor stands to benefit substantially from that move.
So how much to allocate, and what about diversification?
The concept of diversification is for those who do not understand investing. In simple terms, if you don’t want to spend time understanding how your portfolio can grow, you are better off just buying NSE 500 index fund. However, if you're going to generate a return better than the index, you need to build a concentrated portfolio.
Another reason you may want to move away from the index is when you invest only in high-quality companies. An index includes sectors and companies, but all companies may not be of high quality. One critical ratio to evaluate a high-quality company is to look at a long history of high Return on Capital Employed (ROCE).
You might be wondering, why not mutual funds? A mutual fund that operates with the logic of mispricing is better positioned to generate high returns. However, most of the mutual funds that invest in 50 plus companies may not generate a return different from the index. The impact may be more pronounced for large-cap mutual funds. In a way, look for fund managers who create portfolios with 20 stocks and not 50.
“A well-diversified portfolio needs just four stocks.” - Charlie Munger
An expert may claim four stocks, but an average investor may be good with 15-20 stocks. Appropriate diversification must be ensured within the set of these 15-20 stocks.
There are many approaches to stock investing. Most mature investors consider the bottom-up approach. It means to pick stocks based on the company’s performance. A fundamentally strong stock available at a discount is usually a good bet.
There is a possibility that mispricing may happen in a certain sector due to some underlying problem. For example, a rise in crude oil prices will increase the cost for all paint companies. The task should be to select the best in the lot. If you choose all companies within the same sector, the portfolio may be skewed to the forces within that sector.
Once the overall selection is made based on mispricing, you should reflect on the portfolio and address any overlaps. For example, paint companies draw a lot of business from real estate. Therefore, if you have paint companies and real estate companies within your portfolio, the portfolio will be skewed towards real estate. Prudent investors will minimize these overlaps and select only the most eligible investments.
Once this trimming is done, you will see that 10-15 stocks with low correlation will be left. Again, this is prudent investment management that considers the risk of the portfolio as a priority.
To grow your investments, risk management is more critical than return expectations. This is because risk can be evaluated in today’s context, and return will always be in the future. So as far as you take care of your today, tomorrow will take care on its own.
The information on this website and the resources available for download through this website are not intended as, and shall not be understood or construed as, financial advice. You should consult with a financial professional to address your particular information.