You invest to meet your financial goals; earning high returns helps you achieve them faster. But you need to remember that your goal is the ‘dog’, and high returns are the ‘tail’. And as the saying goes, you must not let the tail wag the dog. Far too often people forget this, and chase higher returns without paying heed to risks. Investing is all about the future, and the future is always uncertain. This means you are always exposed to risk. You cannot eliminate risk, but you can and must manage it.
How do you manage risk in investing?
Discipline and Diversification are two effective tools that help you do this. Luckily, both are free, but this does not mean investors use them well. We have seen a large number of portfolios, and it’s obvious that most of us, and by that we mean almost all of us, could do better on both these fronts.
Discipline prevents you from letting your emotions drive your investment decisions
But discipline to do what? Discipline to follow a framework of decision-making; what to buy, at what price to buy, etc. Our entire site is built on a framework of fundamental investing; it is governed by a strong process. This does not mean that it will work wonders all the time, but following the process consistently is essential to meet your financial goals through investing, and also to earn high returns.
Diversification answers the question: ‘How much of each stock should you own?’
It is the answer to the third essential question you need to ask before investing; ‘How much of each stock should you own?’ Our answer is that you should manage a diversified portfolio of not more than 20 stocks. Diversification ensures you don’t put all the eggs in one basket. So, how do you accomplish this? But first, why 20 stocks?
How many stocks ensure sufficient diversification?
Statisticians have studied the volatility of a portfolio with varying number of stocks from 2 to 500 versus the market. They concluded that volatility reduces to a large extent, when a portfolio has 16 stocks, and having more than 32 stocks doesn’t materially reduce the volatility any further. So, we believe the investor must hold somewhere in the range of 20 stocks to get the maximum possible benefit of diversification.
Should stocks be bought equally in a portfolio?
Even though we eliminate the stocks that are red, i.e. not investment worthy, not all companies that make the shortlist are equally robust. So there is no reason to hold all business equally. Some stocks deserve higher allocation than others, especially the ones with a strong and consistent performance capability, the ones with a strong sustainable moat.
Some companies’ earnings are likely to be lumpy due to the cyclical nature of the business. It’s prudent to commit a lower amount to such stocks. At MoneyWorks4me, we recommend that you buy shortlisted stocks in three portfolio weightage categories: 7%-5%-3%.
MoneyWorks4me’s Stock Allocation Strategy:
We recommend 7% of portfolio weightage to superior quality and sustainable profitable growth companies. We invest 5% in most above-average companies with robust cash flows and consistent ROEs, while good businesses but cyclicals, asset-based businesses and leveraged companies fall in the 3% bucket.
Using this allocation strategy, the volatility of your portfolio is likely to be lower than the market, as your portfolio is skewed towards stable businesses, and volatile companies are a smaller portion of the portfolio.
As you can infer, with this allocation strategy, a portfolio can have a maximum of 33 stocks and a minimum of 14 stocks. In all likelihood, 20-25 stock is what your portfolio will have when you follow this process. As you can see, when you only have space for about 20 stocks, you should not be tempted to include mediocre and risky companies in your portfolio.
How to reduce risk further through better portfolio management?
Every good portfolio manager follows some thumb rules to avoid risks that arise due to the composition of the portfolio. There are three such risks and three corresponding good thumb rules that you should follow:
1. Sector Exposure Risk:
Invest less than 25% in any one sector; don’t exceed it. This ensures you are not overexposed to a particular sector. In case that sector faces certain challenges, you can handle the turbulence better. Of course, you need to have selected strong companies within the sector.
2. Stock Concentration Risk:
Our 7-5-3% portfolio weightage method ensures that you are not overexposed to any particular company stock. Even if the stock runs up faster than others, avoid exceeding twice the original allocation, i.e. 14-10-6% by booking some profits.
3. Market Cap Risk:
Small cap companies with a good business model grow fast. Their stock prices rise sharply, and they generate excellent returns. Hence, they may find a place in your portfolio. However, their performance could be strongly affected by an economic downturn, commodity prices, lack of resources, etc. There is the additional risk of not knowing enough about the company, since small caps are not studied as closely as large caps. This exposes you to the risk of poor governance and fraud. If you have a moderate risk profile, you should invest not more than 20% in small caps. This will enable you to participate in the potential for growth from small caps, while limiting the market capitalization risk to your overall portfolio. Simultaneously, invest 60% in large caps with low volatility and steady returns.
In investing, you are always exposed to risk whether it materializes or not. If you invest for a reasonable time, you will encounter risk, and how you react to it will determine whether you will meet your goals.Read our blog posts on Risks at the Portfolio-level and Risks at the Stock-level to know more.
If you have an existing Stocks portfolio, you can identify risks in your portfolio real time, and get recommended actions to reduce them, with our Portfolio Manager, for free! Just register and upload your portfolio.