Stock selection gets a lot of attention but the best investors will tell you the real game is portfolio construction.
Most of us do not pay enough attention or thought to how we go about constructing the portfolio. Yet this one aspect is what makes or breaks your overall returns.
There are many schools of thought on this topic. A lot of us debate feverishly on why one is better than the other and why the other makes no sense when compared to the one.
Most portfolio construction discussions look at one key aspect of this game. Should i be concentrated or diversified? Should i own five/ten/fifteen stocks or should i own thirty/fifty/hundred.
Like with most things in our business, the answer is “it depends”.
So, what does it depend on? Like most things in our business, it’s not what you think.
It does not depend on your “risk taking ability”. Rather it should not.
Portfolio construction should primarily be a function of:
Am I a trader or an investor?
What time frame am i playing?
What type of stocks do i own ?
Am i a trader or an investor?
Traders Good traders, can afford to be concentrated, because by definition they act quickly to cut their losses and don’t allow a concentrated position to kill them. When i say traders, if you are picturing someone doing intraday options, you would be right. They really do take crazy leverage at times - which will seem like concentration of a concentrated portfolio. I digress.
When i say traders, in this context, i really mean those who buy on a mix of fundamentals and price action (which honestly today is most of us.) If price action can potentially make you sell, then you categorise yourself as a trader and as a trader you have the rights to be concentrated if you promise to be a good trader i.e. have an ability to cut your losses. If however you are a bad trader (i.e one who is prone to hope and holding on to losing positions beyond a point) then you should never ever concentrate as it will guaranteed kill you.
As a trader if you cant afford to be concentrated, you have to be diversified but unless you are managing hundreds of crores your returns will be mediocre at best.
Diversification doesn’t work with trading because your average profit percentage per trade wont be phenomenally high - given relatively shorter time horizons - and hence unless you are concentrated (or leveraged) - the math just won’t work out.
So that’s one. Try to be a good trader and earn the right to concentrate.
If you are an investor, i.e. someone who is not bothered by price action but works on a thesis and is willing to wait forever, you are better off being diversified. This is because investing follows power law. One investment that becomes a 50 bagger can take your overall return significantly up even if most other investments have been duds. So it makes sense to take many bets and let the power law and optionality work for you. Not surprisingly this is what VCs/Angels/PEs do.
However if you concentrate as an investor, do not respect price action and get your thesis wrong it can do significant damage to your overall portfolio - sometimes so bad you may not be able to recover from it.
So as an investor who works off a thesis and doesn’t and shouldn’t bother about price - you’re better off diversified.
What time frame am i playing?
Traders typically play the shorter time frames and hence this point is moot.
Investors however can be categorised into those - that play the “normal” 3-5-7 year cycle/time frame and the “Gods” who do multi-generational investing. Now the normal investors have no choice but to remain diversified. The Gods however (i am talking Buffett, Munger, Anthony Deden, Nick Sleep ) can choose to be concentrated investors. This is because one, they are Gods i.e. extremely good investors with unmatched judgement and two, they have access to permanent capital and often float which keeps increasing by the year - allowing their judgements to take time to play out. Not just that, in this period they accumulate more cash/float which not only allows them to average if necessary but if they choose not to average, automatically makes their concentration lower as the years go by.
As an investor you can concentrate only if you belong to the God class of investors.
What type of stocks do i own?
So am i saying a “normal” investor can never concentrate? Of course they can. Just filter and pick stocks where it’s highly unlikely that you will be massively wrong. In the worst case you may not make the returns you desired because you overpaid but you won’t lose your shirt. I am talking the Asian Paints, HDFC Banks and the Coffee Cans of the world. Buffett called them Stalwarts. This is the only legitimate way to concentrate for “normal” investors and if you are able to pick these up during corrections you will do reasonably well.
If you try to diversify with the coffee can types, since none of them will give you an asymmetric fifty or hundred bagger, e you will likely post very mediocre returns and make the exercise not worth it.
If however you want to bet on the likes of Nykaa, Zomato or the small cap chemical or textiles names for the next 3-5-7 years - you are much better off staying diversified. if you take asymmetric bets you are better off diversified as you get more optionality and you still do ok even if most your bets don’t work out and a few do spectacularly well - which they will if you own enough stocks. Plus you will get to screenshot those superstars and post them on twitter.
Therefore:
Good Traders: Should concentrate.
Bad Traders: Should not trade. But they will, so they should stay diversified.
God Investors: Who are we to advice them, anyway.
Normal Investors + Coffee Can/Stalwarts: Should concentrate.
Normal Investors + uncertain bets: Should diversify.
Comments welcome.
I was expecting that you will talk about how many stocks we should keep in portfolio? what are the effects of less stocks as well as more stocks? Statisticians claim , risk gets diversified at 25 stocks, beyond that it doesnot benefit. But again Statisticians have not given enough thoughts about how individual stocks are co-related with each other, so their independence is not properly judged and quantified. Even within a single company, there might be many products of different nature which may provide much needed diversification. Just think of Reliance..It has 7-8 sectors under just one company...so Can it be a proxy to 7-8 sectors diversification? also warren and Charlie recommend 5-6 stocks, even Fisher says so..They call investors who invest more than that as Fools...But can we really know the company inside out? In the name of research we can read annual reports, listen to concalls, read rating agency reports and watch management interviews and other investor interviews....Beyond this , what we can do? can we get inside the Boardroom of directors and listen to what directors are discussing? So really I hope you dwelve more into Portfolio construction....First you need to identify prominent sectors which are important for Indian economy...and we need to invest in those sectors at all times...Then you need to idebtify leaders in those sectors and then arrive at number of stocks...i expect a lot from you...please oblige....
My investing experience is precisely articulated.