Blogs from Capital Portfolio Advisors

Concentration or diversification of a portfolio could be done based on stocks, sectors or market capitalisation. In this article, we discuss based on stocks. Whether to have a concentrated or a diversified portfolio, is a dilemma faced by several investors. Once this dilemma is addressed, the next one is about the quantum of concentration or diversification! While there are no fixed rules that help solve this dilemma, through this article, we will attempt to prepare a base for the thought process.

The first question that an investor needs to clearly define his/her investment objective and his/her risk tolerance. “Maximising wealth” could be the most common investment objective. Some expectation of return could make the investment objective clearer. While most equity investors would theoretically be willing to take risks, but, practically, most are very fickle and would scramble to exit a “long term investment”, indicating that their risk tolerance is low. A long term investment horizon is suggested for both the strategies, but, more so for the concentrated portfolio strategy.

Once these 2 key queries are addressed, one needs to check the size of the investible universe and it’s variety. India is blessed with a wide variety of business segments, in the listed equity space. It would perhaps be the second best, in terms of variety after NYSE. In a fast growing major emerging economy like India, several business segments could be firing up simultaneously. Hence, investors would have the luxury to choose from this large canvas. No one segment dominates the economy, for a long period of time. Each major segment could have several sub-segments that are large enough and could be growing well, e.g. the Banking & Financial sector takes up about a third of the Nifty weight and this is the largest weight. However, there are several sub-segments within this space – the NBFCs, banks, insurance, asset management, micro-finance, etc. Inadequate or non-exposure to some of such fast growing segments could lead to opportunities being missed out. Hence, it may make sense to have a portfolio that has exposure to such fast growing segments, without spreading too thin.

In countries like South Korea, Japan, Taiwan, Brazil, etc. fewer business segments dominate the economy. Hence, country specific portfolios, in these countries, may have portfolios that are fairly concentrated, not by design but due to the nature of the economy.

The next point that needs some thought is the investor’s bandwidth to monitor a portfolio. Every position in the portfolio needs careful monitoring of fundamentals and valuations. It would be humanly impossible to monitor a large portfolio, for an individual investor. Hence there needs to be an optimum trade-off between the desire to have as many high quality businesses as possible and an investor’s ability to monitor the portfolio.

Concentration is for investors who have great conviction in their investment ideas and are willing to stay invested in them through thick and thin. Probability of making big gains is higher in concentrated portfolios.  It works better for bottom up investors rather than top down portfolio managers. Best known stock pickers have been known to have concentrated portfolios. Returns in this strategy could be lumpy. Hence, the investment horizon needs to be sufficiently long. In terms of risk, any change in business environment, especially in today’s highly dynamic and unpredictable world, could impact the fundamentals of any of the concentrated bets. One bet gone awry, could impact the portfolio performance significantly! 

Diversification reduces risk in the portfolio.  It could smoothen volatility and steady returns over the longer term, by having stocks with varying correlation.  It helps an investor to benefit from a clutch of fast growing sectors, of the economy. Diversification is usually used by institutional money managers. The risk in this strategy is the inability to make outsized return in the event of a bet working well. The other risk is the risk of making sub-optimal returns due to varying risk-return trade-offs, especially in a highly diversified portfolios.

Having understood the pros and cons of these strategies, let’s understand how concentrated or how diversified should a portfolio be? This is a subjective aspect and varies from investor to investor. An investor could have as concentrated a portfolio of 5 stocks or have as diversified a portfolio of 100 stocks. It depends on one’s desire and ability to own and monitor a certain number of stocks.  In our view if one needs to have a concentrated portfolio, a number of between 5-10 stocks, should be a good number. For an optimally diversified portfolio, a number of between 20-25 should be fine.

What do we do at Capital Portfolio Advisors?

We advise HNIs on their equity portfolios, depending on their investment objectives and risk tolerance. We currently run our optimally diversified model portfolios that have stocks numbering between 15-25. All of these stocks are growth stocks with sound managements, bought with a moderately longish view. We try to pick stocks that have businesses that have predictable and sustained growth over the foreseeable future, under current circumstances. This strategy has helped us perform well as compared to competition and the indices, consistently.

We suggest retail investors, if they are on their own, to start with having an optimally diversified portfolio strategy and keep on reducing the number of stocks over time, as confidence builds up.

Happy investing!

Disclaimer

This article has been written by Team Capital Portfolio Advisors. Mr. Paras Adenwala, Founder of Capital Portfolio Advisors is a registered with SEBI as an Investment Advisor. Any part of the content of this article should not be construed as, an offer or solicitation to buy or sell any securities or make any investments. The content shall not to be relied upon as advisory or authoritative or taken in substitution for the exercise of due diligence and judgement by any user nor should it be used as a basis for making any decisions, without exercising user’s own judgment or diligence. As a condition for using this Blog, the user agrees that Capital Portfolio Advisor (CPA), its Founder or any of it’s employees make no representation and shall have no liability in any way arising to them or any other entity for any loss or damage, direct or indirect, arising from the use of the Blog. CPA reserves the right to change the content of the Blog without prior notice.

4 comments on “Equity Portfolio Strategy: Concentration v/s Diversification

  1. The normal tendency of majority of Indians is to buy stock and hold it for a long period. This ‘Concentration’ behaviour is very aptly described in this note. Moving them to diversified rationale is a bit tough task.

    1. Thanks for your comment.

      “Habits dies hard”!. However, markets do force several investors to tweak their investment habits/strategies and begin respecting risk.

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