Building a stock portfolio

By May 15, 2017 Trading 2 Comments
Building a stock portfolio

Portfolio construction can be very taxing in this complicated world. Yet it is very important for every individual. Little care has been taken to simplify it by the financial industry. We would like to address the problem through this article.

Portfolio construction, just like a doctor’s prescription, cannot be done without assessing a person’s condition. Two keys to assessing one’s condition – Ability and Willingness.

ABILITY

Roti(1), kapda(2), makan(3)” is a cliché term for a reason. Before even thinking of portfolio a person should think about margin of safety which should be about ensuring family’s basic needs. Health(4) and education(5) form a critical component and should be above in priority to most other things in life. “Makan” may or may not be owned and can be rented too. We will group the above five as “tathya”.

Age and inherited wealth also determine a person’s ability to take risk. A younger person or a person born in a rich family can afford to take more risk compared to others.

WILLINGNESS

People choose different professions and ways of life, some like taking risk and are comfortable with uncertainties. An artist is driven by passion instead of needs. Adventurists risk their lives in extreme sports and astronauts in space travel. Hence to each his own. Same is true for financial markets. People have varying degrees of willingness to take risk. Fixed income, real estate, gold and equities all have different attributes and their returns differ not only in terms of magnitude but also in terms of risk and volatility in the longer run. Gold can give happiness to most wives and real estate a sense of comfort to most families. A sense of ownership along with returns might drive some. Equities are for those who believe in capitalism boon to humanity in creating long term wealth. It can be both volatile and rewarding. A person must decide where he or she wants to be.

Also Read : Which is a better decision: taking a home loan or buying once I have the money?

Steps of Portfolio Construction

1) Place money aside for 5 “tathya” – roti, kapda, makan, health, education

2) Keep money for real estate, gold or fixed deposits/bond funds if they are your preferred choice to place your capital

3) For equities, make a Systematic Investment Plan(SIPs). Invest monthly corpus.

4) Sleep peacefully

How to Invest in Stock Markets

Mutual Funds :-

  1. The first option and for novices a better one is go through mutual funds and do SIPs and invest a monthly corpus through a set of funds.
  2. Screen the funds based on the assets under management of the mutual fund and atleast 5-yr performance vs its benchmark index. There are different types of funds in the market and one must select funds based on specific information or advice otherwise its best to select diversified funds and not sector specific. Mutual funds globally are preferred investment route for masses to invest in equities and are recommended if you do not have time, expertise or inclination to build a stock portfolio yourself.

Building a stock portfolio yourself

There are a few points that one should be clear on before starting to build a portfolio. It requires skill and time. Also risk in stocks comes from uncertainty, volatility and unknowns. More precisely it is about handling our psychology in reacting to those factors. Emotional balance is a must.

Once an individual is clear with the above then we can go ahead and discuss the rules of the game (borrowed wisdom from the genius Warren Buffett)

  1. Never lose money. Simple math is if you lose 50%, you must make 100% to get back
  2. Diversify unless have understanding to run a concentrated portfolio. A portfolio of minimum 8 stocks and maximum of 20 is recommended.
  3. Invest in real tangible businesses and not on hype and hope
  4. Heads I win and tails I don’t lose much should be the mantra, always assess risk reward in an investment
  5. Who runs the show is important, quality management is highly recommended

Risk: Generically speaking, risk is any investment comes from us not understanding it. Contrary to this you can never predict the future, it’s always a calculated bet. A portfolio should diversify risk based on market sectors, company size and correlated stocks.

Style: Growth and value are two broad styles of investing wherein growth stocks because of their faster increase in turnovers and profits are expected to outperform benchmarks and value is whose intrinsic value of the business is greater than what the market values them as. Based on a person’s risk tolerance and style he may go for an appropriate weighting of stocks in his or her portfolio.

Rebalancing: An established portfolio needs to be analysed and rebalanced periodically, because market movements may cause initial weightings to change. To assess portfolio’s actual asset allocation, quantitatively categorize the investments and determine their values’ proportion to the whole Categorize your positions as over weighted or underweighted. For example, if you are holding 40% of your current assets in small-cap equities, while your asset allocation suggests you should only have 25% of your assets in that class. Rebalancing involves determining how much of this position you need to reduce and allocate to other classes.

Diversifying and aligning portfolio based on sectors and market capitalization is important. Align investments based on your psychology and comfort. Sectors like FMCG, pharma, IT come under defensives as these stocks tend to outperform during market downturns. Sectors like banks, autos, real estate and housing finance companies are interest rate dependent. Sectors like metals and commodity stocks are cyclical in nature. A portfolio weighting should be adjusted itself based on bull and bear market phases and based on commodity and interest rate cycles. A second consideration is based on market capitalization – small cap, midcap and largecap stocks. Smallcaps usually outperform midcaps and largecaps in bull markets and underperform in bear markets. The risk(beta) is higher generally for smaller companies. A portfolio should be balanced in terms of exposure to large, mid and small cap companies.

Tax considerations: A portfolio should be designed and rebalanced taking into consideration the effect of taxes. Short term capital gains in India is 15% and long term capital tax is zero. A holding of more than a year is categorized as a long-term investment. Hence an investor is better off picking stocks for more than a year so that he benefits from taxation perspective.

Portfolio turnover: There’s been a huge debate globally of active vs passive portfolio management. Active portfolio management results in huge turnover and hence can reduce returns drastically over a long period of time. Hence rebalancing of a portfolio should be done taking care of the costs involved in churning a portfolio.  

Also Read : Fixed Deposit v/s Equities – Which is better?

Portfolio construction should take care of the following points in a nutshell

  1. Risk
  2. Style
  3. Diversification
  4. Rebalancing
  5. Tax
  6. Turnover

Happy Investing!

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2 Comments

  • Vinit says:

    Sine app is very good, but only one drawback is sine app does not provide online portfolio

    • Trade Smart Online says:

      Hello Vinit,
      Kindly let us know what exactly mean by online portfolio. What information would you like to see in the online portfolio? We shall check upon the same.

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