7 Golden Rules Of Portfolio Management

Most investors participate in the market looking at the historical returns of either the indices or some of the multi-baggers. Nothing is more impressive than the historical returns of a proven multibagger. Once an investor starts his investment journey, the results for most investors do not match their expectations. Majority of investors would acknowledge the fact that the investing experience is not that easy as was initially thought. In fact, the business of investment is extremely rigorous and intellectually challenging. 

For some, it is simply buying a promising stock at a lower price and then selling it at a higher price eventually. For few, it is all about research and analysis and for others it is all about luck.



What then drives the investment performance for any investor? Is it the superior stock selection ability or is it all about market timing or is there something else that drives the investment performance. A closer look at how most of the investors have made money will explain what distinguishes making money from losing money in equity markets.

The key to any investor's investment journey is the way the portfolio (equity) is managed. Says Amit Pokharna, who is a chartered account by profession and is an investor since last two decades, “The way I study markets is, I study the market history first (running into last three to four decades), then I try to understand how markets have behaved at different times and how ferociously markets have corrected and why. Then I look at who has made money in the markets and how. After that, I look at how the stocks were selected and by using which study. Time and again, I come to a conclusion that most people who made money in the markets managed to build their portfolio well keeping in mind the science of portfolio and all the successful people had the gumption to hold on to their portfolio for a really long time”. What is portfolio management and why should an investor take a portfolio approach instead of investing in individual stocks?

Portfolio management is management of securities in such a way so as to fulfil an investor’s financial objectives. Obviously, a different financial objective will call for a different portfolio and that is exactly the reason why we have different portfolios for different investors. Ideally, the objective of any portfolio is to maximise an investor’s return for a given level of risk or to minimise risk for any given level of return.

In investment parlance, risk is defined as variation of the return from what was expected, i.e risk equals to volatility in investment world. Standard deviation is a statistical tool that quantifies the risk. The objective of any portfolio should be to maximise returns while keeping the same or lower standard deviation for the portfolio. When an investor invests the entire portfolio amount in one stock, the standard deviation remains quite high, i.e., the variation is high. The moment an investor adds uncorrelated stocks in the investment portfolio, he can expect a drastic drop in the standard deviation of the portfolio while keeping the expected return same as in the case of a portfolio where 100 per cent of the money is invested in a single stock. The trick here is to identify quality unrelated stocks to minimise risk without actually compromising on returns. Thus, the composition of the portfolio is of great importance and one must understand that different portfolios have different risk-return trade-offs.

Thus, constructing a portfolio diligently is critical to anybody’s investment journey in the stock market.

Three important steps in the portfolio management process:
1. Planning step (Investment Philosophy and Policy)
2. Execution step (Portfolio Construction)
3. Feedback Step (Portfolio Performance Evaluation)

A deep dive into how technical analysis can support to boost your investing performance:

Typically, there are three main approaches that financial services industry counts on to make investment decisions: the fundamental approach, quantitative approach and technical approach.

What is technical analysis? Technical analysis focuses on the study of market action, which includes price and volume as a principal source of information through the use of charts.

There are three essential premises on which the technical approach is based. The first basic premise suggests that the market discounts everything. The second premise suggests that prices move in trends. The third premise is that history tends to repeat itself.



What factors should an investor consider in building a watch list of stocks?

Trends and Trendlines:
The trend is the direction in which the security is moving. Trendlines are the least difficult and single most vital device in your trading arsenal. Prolonging a line off the key highs and key lows in price is an objective way of assessing the gradient or slope of a trending market. This key step can help distinguish where the price is probably going to discover support or obstruction. If prices are generally rising and making sequence of higher highs and lower lows, then we have an uptrend. What makes trendlines significant? A trendline ought to connect a minimum of two peaks or two valleys, ideally at least three or more. To what extent the trend has been in force. The longer a trend has been in power, the more vital it becomes and the more we should focus when it is broken. Another important factor to keep an eye on using a tredline is to see volume expansion in the direction of the trend. An uptrend should see expanded volumes to give purchasers certainty. Contracting volume in an uptrend is a caution sign.

Moving averages:
Moving average is one of the simplest, but useful tools in the armoury of a technical analyst. For short term traders, 8-day, 21-day and 50-day are widely followed, while any investor or trader applying moving average that uses 100-day or more, can be considered as measuring the long term momentum.

Prices above these averages, but not too far above them, tell us more about the trend. When prices move below them, then a change in the trend may be in progress.

Volume and momentum:
These two indicators affirm the soundness of a pattern or signal a caution of a looming change.

Relative Strength:
Relative strength alludes to how solid a stock is in respect to some other security. This could be either how solid it is contrasted with the general market or the industry group it is in. If it is resilient, then we say that it has relative strength. If it is weak, then we say that it has relative weakness. The hypothesis is that we should purchase a solid stock in strong sectors.

How to scan for the best stock for portfolio: The Process
Now that we have given a fair idea about the key technical tools, let us look at the process of going from a stock idea to an actual decision to buy or sell.

Identify the trend:
The first step is to identify the trend or one that is about to emerge. Decide if the trend is healthy: To confirm that the trend is a healthy, we need prices to be trading above a relevant moving average, but not so far over that the stock is inclined to revert back to mean.

Confirm the trend:
Confirm trend with the use of volume and momentum indicators.

Ascertain whether the stock is leading a benchmark or its peers: Is the particular stock at least matching the performance of the market and its peers?

On the off-chance that the stock passes each of these tests, we have a possible candidate for purchase.

Golden rules of constructing portfolio:

Rule no 1

Risk Profiling

Any investor who wants to start his journey in equity markets has to get the risk profiling done first. Risk profiling talks about the emotional tolerance for risk and much more. Risk profiling helps an investor understand himself/herself better and helps a lot in deciding the asset allocation strategy.

To put it bluntly, a sincere effort on risk profiling should help any investors determine – how many large-caps, how many mid-caps and how many small-caps should ideally be in the portfolio. This is the first step in the right direction and this step should put investors in an advantageous position.

There are many investors who are involved in the markets for years together, however they have not done their risk profiling, and hence, they fumble more often than not in volatile markets.


Rule No 2 

Choose Your Investment Horizon For The Portfolio And Not For Individual Stocks

It is very common to see investors vaguely deciding on the investment horizon. Most people consider one year as long term, few consider three years, while few others consider five years as the long term. Actually, it could be hazardous for the portfolio health if one keeps a rigid tenure as long term.

Ideally, any investment horizon can be kept for a portfolio and not for individual stocks as the long term will vary for each portfolio constituents depending on the nature of its business and industry. The tenure for the portfolio can be three years or five years; however, the individual stocks in the portfolio can be sold after initial purchase within three months, six months, one year or three years.

A lot of investors promise themselves to hold the stock for one year no matter what fundamental changes take place within the company. Few investors promise to never sell the stock even after they see the fundamentals of the company deteriorating.

The concept of long-term investment horizon is uncertain for majority of investors. Ideally, it is the portfolio tenure that should matter and the holding tenure of individual scrips can be flexible depending upon the prospects of individual scrips.

Rule No 3

Understand what you are buying

It is of paramount importance that investors understand what they are buying, because without such an understanding, an investor may face some serious financial losses. Every investor's approach to investing should be guided by common sense. Unless an investor understands the basics of what makes the company tick, the investor will not be able to value it. If an investor does not know the worth of the company, he will never know how much to pay for such a company in terms of its share price. The starting point for any investor should always be the annual reports. Annual reports help investors with not only the basic information about the company, but also about its suppliers and customers, the source of competitive advantage and, most importantly, how is the company making money.

It will be of great help if an an investor puts effort in understanding the overall manufacturing process if it is a manufacturing company and understanding its industry status. An investor can focus on simple businesses as these are easy to understand and hence easy to value. Those companies that possess ‘economic moats’ via monopoly or otherwise and yet are simple businesses to understand should be on the radar of any investor because such businesses show stable and predictable earnings.

Remember, while investing there is always a craving for novelty and we find ‘simple’ too boring. Investing and portfolio management can be boring at times. An investor ought to study the pricing power of the company and let common sense prevail before buying any stock.

"The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell."
 -Sir John Templeton (Investor and mutual fund pioneer, 1912-2008).

Rule No 4

Don’t Buy Any Stock Without Studying The Company's Balance Sheet

As investors, we are always obsessed with P/E ratio, profitability, profit margins and profit growth. Come results season, it is indeed the growth in the profits QoQ and YoY that make the headlines. However, it is indeed the balance sheet that one must read to understand the financial health of the company. Balance sheet provides details of the assets and liabilities and equity capital of the company.

An analysis of the balance sheet will give investors insights on how much debt a company has, whether inventory is piling up, is the company investing its surplus cash wisely or allowing it to sit idle for too long.

The key is to study the debt level of the company. Investor should not miss it at any cost. A strong balance sheet often suggests that the firm can put to use spare cash for expansion or deploy it for new profitable ventures.

While studying balance sheet, an investor should also remember that a balance sheet can be inflated at times due to “ambitious” valuation of assets. Usually, the intangibles (goodwill, intellectual property, brands) are valued inaccurately and placed under the assets. Investors should be careful as to how the company is treating its R&D expenditure, i.e., whether it is treating it as an expense or capitalising it and adding to the balance sheet. Special attention needs to be given to the money raised by corporates via hybrid instruments. Investors also have to pay attention to any debt incurred that does not fully reflect in the company’s balance sheet. Balance sheets act like a backbone for any company and it should be studied in detail to understand the true character of the company.

Rule No 5

Diversify Portfolio Only To A Reasonable Extent

A majority of the investors do understand the importance of portfolio diversification, but their implementation of portfolio diversification is erroneous at times. There are two observations here, namely,

1. Investors stuff in more number of shares than is required, thus diluting returns and making portfolio unmanageable.

2. Investors add those shares to the portfolio that are highly correlated.

Merely having a greater number of shares is not diversification. To derive maximum benefit from diversification, only those fundamentally qualified shares should be added that are uncorrelated with the portfolio stocks. For example, if the portfolio consists of two or three banking stocks, adding stocks from FMCG or oil & gas or specialty chemicals would be a much smarter move rather than adding another banking stock. Adding uncorrelated stocks to the existing portfolio is the key to reducing the overall riskiness of the portfolio. Thus, it is not enough to merely identify if any stock is fundamentally qualified for investment, enough attention needs to be given to ascertain whether it can add value to the portfolio diversification and whether it is showing less or no correlation with the existing stocks in the portfolio.

Also remember that portfolio diversification may not work during market correction; however, under normal market conditions, portfolio diversification is very useful.

Rule No 6

Take Advantage When Markets Are Irrational

After studying the market history, one thing is for sure that the markets can be irrational at times and that markets tend to overreact both on the upside and downside. Portfolio management is an active process. While restructuring the portfolio, an investor has to gauge if there is any excess movement happening in the market both on the upside as well as downside. Investors need to know the long-term averages for key valuation ratios such as P/E. If the markets are trading at substantially higher than the long-term averages, one needs to be cautious and when the markets are trading at a steep discount to the long term averages investors need to get hungry for buying more shares.

An insightful analysis of the market situation is the key here and accurate inference on what is happening in the markets can make the difference

Active management of the portfolio and regular profit-booking is a good recommended exercise that can keep an investor's portfolio healthy

Rule No 7

Do your own research

One of the most common errors that investors make is “not doing their own research”. Without doing own research, whenever an investor participates in the market, he runs a risk of being lost in the market when the prices do not move as per investor's expectation. Over-trading and getting stuck with poor quality stocks is a common problem faced by investors who do not do their own research.

A clear stock selection strategy needs to be chalked out. What kind of shares need to be in the portfolio, whether there is any preference for sectors, what should be the weightage of each stock in the portfolio, whether an equal weightage portfolio should be created, whether high dividend yielding stocks should be given more weightage, whether growth stocks or value stocks should be a part of your portfolio, whether top down approach should be adopted or a bottom-up approach is to be adopted, and many more such questions should be answered while doing your own research on the companies.

For example:- What we have observed is, if we scan through all the listed shares with market cap greater than Rs.1,000 crore and identify only those shares that have consistently distributed dividends in the last five years, we find that the average returns of such stocks do not beat the Sensex returns.

However, if we filter only those stocks where the EPS (earnings per share) growth has been better than the DPS (dividend per share) growth YoY over the past five years, the average returns of such set of stocks is better than that of Sensex.

Investor ought to focus on a particular stock picking strategy that is easy to execute and is uncomplicated.

Mustafa Nadeem, CEO, Epic Research

"Wealth creation is a Marathon, not a sprint"

An average investor does not have access to a lot of sophisticated platforms/algorithms that are highly used by big money across the markets. However, in this free world, she/ he does have access to information, disclosures and tools which can help carve out a good portfolio. Most of the information is publicly available on exchanges and other financial websites. There are a few Golden Rules which are mostly practical in nature and can be followed diligently when building a portfolio.

1. Risk management:
There are many allocation methods in practice, the simplest being allocating equal capital to all investments. How much risk can you afford varies for everybody. There are no standard criteria. One should, however, not risk more than 5% of capital on a share and not more than 25% on a particular asset class. The math behind it is very simple. If I have Rs.10 lakh, I will not invest more than Rs.2.5 lakh in equities.

With the remaining amount, I can add other investment avenues such as mutual funds, commodities, gold bonds, etc. If you only wish to add equities, do not invest more than Rs.50,000 in a particular share. Also, never risk more than 2.5% of your capital. So, I will personally never take a loss more than Rs.25000 in equities. These small practices will keep your downside protected.

2. Statistics:
You should be able to understand the dynamics of your portfolio. For example, you can have a portfolio level PE where you track the PE of your portfolio against the market.

This way, you will know when your portfolio is undervalued or overvalued against the market and you need to make some changes. You can also calculate the returns you have made historically. So, once you know you have outperformed the market. never hesitate to book some profits. On the other hand, you will know when to sit on some cash, which is not bad.

3 Discipline and patience:
Always be disciplined, you must remember that stock prices fluctuate on a daily basis, Value does not. Wealth creation is a Marathon, not a sprint. So, be steadfast with your goals and don’t get to the edge of your seat because your stock is the top loser of the day. Never pay heed to the noise and diligently follow your rules. In the end, patience will pay.

Pritam Deuskar Fund Manager, Bonanza Portfolio


"Diversification should be a byproduct of selection of good bets"

The important and profound things during portfolio management I think are:

1] Portfolio should be concentrated to 12-15 stocks. Over-diversification dilutes returns. Diversification should be a byproduct of selection of good bets that one adheres to and should not be done for the sake of doing it.

2] Maximum allocation to a stock can depend upon risk appetite of the investor, but we feel it should be restricted to 15%. Sector-wise, it should be max 25%.

3] Buying in a stock should be in staggered manner. Never allocate less than 3%, but gradually we should go on adding when things start working in favour of the portfolio. Also, over the period, you get to know more about the company, management's execution of plans and response by the stock market.

4] If you select a very good company at very high valuation, you may lose money or have to wait for long. If you select a mediocre company and high valuation, you are bound to suffer. Valuation is the key to returns. Quality is not a factor that can be compromised. You remember it more when market falls.

5] Being in long term equity, there are no stop losses, but still one should take a hit if business economics change and exit at 30% loss if something has gone wrong with the way company operates or with management integrity.

Jimeet Modi Founder & CEO of SAMCO Securities Ltd



What is more important is where not to invest

How best to manage risk in the context of personal portfolio?
Diversification is the most common tool to manage risk, but blind diversification alone may not generate superior returns. For example, a layman may invest in 10 different sectors selecting best in the lot. But this will not generate superior risk-adjusted returns. In order to manage risk at the portfolio level, what is more important is where not to invest. Sectors like Power, Cement, Infra, Trading and Real Estate should be avoided as from a long-term perspective these sectors do not generate compounded returns. Investing in Financials, FMCG, Pharma, Consumer staples & electronics would protect the portfolio's returns on the downside and at the same time generate above-average returns over a long period of time. Warren Buffet has more than half of his investments in Financials, although this may seem concentrated, he has managed the risk by investing in a bunch of banks and financial services providers.

How to manage portfolio risk in falling markets Vs rising markets?
Designing the portfolio in the above manner would protect the investors from the downside risk with a minimal dent to the portfolio as there is an insignificant proportion of cyclical sectors in the portfolio. A portfolio can never be immune to downside risks, only thing is to restrict the dent to a minimum. Plus the portfolio should simultaneously have the ability to bounce back, which it will because of the sectors with which the portfolio is designed and at the same time, the leaders within the sector will certainly rise again when the tide turns favourable. Warren Buffet has more than half of his investments in Financials, although this may seem concentrated, he has managed the risk by investing in a bunch of banks and financial services providers.

Warren Buffet has more than half of his investments in Financials, although this may seem concentrated, he has managed the risk by investing in a bunch of banks and financial services providers.

Conclusion 
Investment management or portfolio management is a process-oriented exercise. It is a rigorous activity which needs monitoring of not only the stocks, but also the process that is followed. Often the distinguishing factor between the successful investors and not-sosuccessful investor is the “discipline factor”.

It is important that a detailed investment plan and process is penned down before one starts his or her investment journey. Investment plan and process should cover the broader aspects as to how the portfolio should be designed, including the details of asset allocation. The stock selection parameters need to be predefined for an optimal outcome. Each of the golden rules discussed in the article, if followed sincerely, can help investors achieve much more from the markets than they are currently achieving.

The quality of predefined investment process and the ability to diligently follow the steps in the portfolio management process should provide an investor the edge.