Have You Weighed Your Portfolio Weights Carefully?

It is crucial that investors have a strategic perspective when it comes to equity investing. Portfolio weighting strategy is often ignored by a majority of investors in their initial investment strategy. Yogesh Supekar & Tanay Loya bring forth the huge benefits of focusing on portfolio weights of individual stocks for beating the markets.

Markets are at record highs globally and Indian equity markets are no exception. In spite of such a spectacular upmove in the stock prices, you will find that majority of the investors are not able to outperform the relevant benchmark index. Even for a professional fund manager, it is a tough challenge to outperform the benchmark index consistently over a long period of time. The fact that almost 58 per cent of large-cap oriented mutual fund schemes have not been able to outperform their benchmark indices when we consider a ten-year period speaks volumes on the chances of beating the markets. 

Why are investors not able to outperform even in a bull market phase that we are in currently? What determines portfolio performance? Is stock selection and market timing the ultimate mantra for beating the markets? Or is there something more to ‘portfolio outperformance' than simply identifying stocks and timing the market right? Well, we have observed that investors tend to focus only on certain aspects of portfolio management and ignore some of the most essential aspects over time.

To understand what determines performance of a portfolio, one must simply focus on the basics of portfolio management and get every aspect of portfolio management correct. This way the odds of beating the market increases manifold. There are very many investors who do not even adopt a portfolio approach in equity markets and are prone to participate in markets randomly. 

Our observation after interacting with lakhs of investors over the past decades suggests that investors err on portfolio construction and majority of the investors do not allow their investments to grow. In other words, majority of the investors take a short-term approach towards equity investments and this is at the root of a big chunk of the under performance. 

One of the most neglected aspects by retail investors in equity investing is the portfolio allocation, assuming that an investor adopts a portfolio approach towards equity investing. Unfortunately, there is not much of empirical research available on the subject which can help investors to determine scientifically the most appropriate portfolio weightages that investors can assign to a particular stock in the portfolio.

For a portfolio to outperform, we believe there are at least three things that any investor should be able to get right:- 

-Investor should know which stocks to buy and when (stock selection and market timing)
- Investor should know how much to buy of each share (portfolio weightages)
- How long to hold on to the investments (Long-term) 

Even though it sounds simple to know the aforesaid three things that can help investors beat the markets, practically it is not always easy to identify the optimal portfolio weightages. That is the reason why portfolio management is considered a mix of art and science. 

While there is abundance of research available on ‘How to identify quality stocks?' and on ‘market timing', there is not much literature available on how to assign portfolio weightages. 

How does an ace investor know how much to bet on which stocks? Isn't it worth pondering what must be going on in the ace investors mind while making decisions on portfolio allocations. The point we are making here is- While majority of retail investors do focus on the stock selection aspect of the portfolio, it is observed that portfolio weightages do not get the attention they rightly deserve.

It is absolutely important that an investor focuses on determining the portfolio weightage aspect as much as he or she does on selecting the stocks that can be a part of the portfolio. The portfolio weighting is crucial and can often determine the success (or otherwise) of your equity investing adventure. 

Most of the successful money managers will have a proven track record of investing a greater percentage of their money in stocks that do well and place lesser amount in bad picks. That judgement, that ability to allocate higher weightage to winners, comes from experience and cannot be formulated in order to be used or replicated by one and all. However, it is highly recommended that investors start focusing seriously on the portfolio weighting aspect of portfolio management as we find that portfolio weighting along with stock selection are the key determinants of portfolio performance. 

To beat the markets, portfolio weighting needs to be taken care of along with market timing and stock selection. For example, let us say an investor has selected HDFC Bank for investment purpose in the portfolio and assigns a weightage of 10 per cent to the stock. If the stock goes up by 30 per cent in one year it would mean that HDFC Bank will contribute almost 3 per cent to the portfolio returns. If the investor had allocated merely 1 per cent of the portfolio to HDFC Bank then, in that case, the contribution of HDFC Bank to the portfolio would have been a meagre 0.3 per cent assuming HDFC Bank inched up by 30 per cent in one year." 

One of the perennial problems faced by investors is also on the number of stocks to be included in the portfolio that should be good enough to beat the markets. There is no empirical evidence that throws up a specific number, however there is widespread belief amongst the experts that a concentration strategy is essential to beat the markets. Several studies have shown that 13 to 20 stocks diversified across sectors are good enough to minimise the risks of the portfolio. Any further addition to the portfolio beyond 20-odd stocks will not meaningfully help improve the portfolio performance, neither will it help reduce the risk of the portfolio substantially. According to Ritesh Asha, Chief Strategy Officer, KIFS Trade Capital, "If an investor adds more stocks in the portfolio beyond 30 stocks, it would not reduce any further risk in the portfolio. On the contrary, it would make the portfolio unnecessarily large and the good performance of any one stock would not be able to produce meaning impact on the total portfolio performance. Increasing the number of stocks beyond 30 might prove counterproductive for the investor. The ideal number of stocks in the portfolio is an outcome of the investor's risk appetite." 

Portfolio weighting and rebalancing are useful risk management strategies for value investors.

What is portfolio weighting?

An asset's percentage in a portfolio is its portfolio weighting. The calculation for portfolio weighting is determined by dividing the current value of the asset(s) by the total value of the portfolio. 

Portfolio weighting can be determined by the amount of confidence an investor has in the stock. For value investors, the largest factor would be the price or value of the asset(s). Stocks with the highest margin of safety ideally should have the largest weightage. 

Amar Ambani, Head of Research, IIFL Investment Managers.

The importance of asset allocation and portfolio weightage can never be over-emphasizsed. The bulk of portfolio returns can be attributed to the asset allocation decision and a smaller percentage to the instrument selection decision and market timing. Imagine a scenario where a person seeking a multibagger 'tip', parks Rs.5 lakh in a stock on his friend's advice from his wealth of Rs.10 crore (largely parked in bank fixed deposits). Now even if the said stock appreciates and swells his original investment to Rs.15 lakh in quick time, he cannot view the gain in isolation. He must see how much his net worth has appreciated in a year. In this case, instead of looking for equity tips, he would be better-off, focusing on moving a major portion of his fixed deposits into other debt instruments such as debt mutual funds, tax free bonds; even equities if it matches his goal and risk-appetite. 

Talking of stock portfolio allocations, fancy notions of diversification or simply the lack of understanding of weightage importance often results in wayward investments. Not just retail investors, I have seen scores of HNI clients left with equity portfolios comprising umpteen number of stocks piled up over time almost without rhyme or reason (some of them suspended and delisted scrips!) 

In case of large-caps, it is prudent to decide the weightage — whether overweight, underweight, or neutral - benchmarked against the Nifty/Sensex for the specific sector or stock. This comparison offers credible sectoral insights based on which, one can chart his or her own course, either of placing a bigger percentage bet, reducing exposure, or going neutral. In case of mid-caps, if one has zeroed in on some stocks based on high conviction, it's important to commit deep. But there are times when I see positions in small-caps and mid-caps being 0.2% of portfolio and 100-plus stocks, making it difficult to monitor as well. 

Portfolio weights make sense not just from the return perspective, but also from the standpoint of risk, liquidity and investor's goals. For instance, investors wanting to limit risk can remain disciplined by assigning a maximum allocation to mid-caps in their portfolio. Also, large-caps with bigger free float will be highly liquid, whereas a small-cap may carry big impact cost, especially when you want to cash out. Portfolio weightages help make these decisions.

If we compare the performance of Portfolio A versus Portfolio B, one can immediately analyse the impact of portfolio weighting on the final portfolio performance. By merely playing deftly with the portfolio weightages, an investor can improve the overall portfolio performance immensely. While there is no sure shot way of knowing which stocks will outperform the others in the portfolio, a seasoned investor usually invests a significant portion of the portfolio on the stocks that are high on his/her conviction list. Ideally, a portfolio should be weighted in direct proportion to how much confidence you have in each pick. Goes without saying that if an investor has a lot of confidence in the long term outlook and the valuation of a stock, then it should be weighted more heavily than a stock which is being included in the portfolio by the investor simply for diversification purpose only. If investors find it too complicated to properly allocate weightages to individual stocks, a simple portfolio weighting strategy that can be adopted is "equal weightage strategy". Equal weight is type of weighting that gives similar weightage or importance to each stock in the portfolio. In an equal weighted portfolio, the smallest of companies are given the same weightage as the large-cap companies. For similar stocks portfolio such as Portfolio A and Portfolio B, if equal weightage strategy is adopted, the performance is nothing short of impressive. Logically, why equal weighted portfolio may outperform is easy to analyse. In equal weighted portfolio, an investor will tend to give similar weightage to small-cap, mid-cap and value stocks as to the large-cap growth stocks. Historically, it is proven that small-caps and mid-caps have provided better returns than large-caps, and hence, there is a better chance of portfolio outperformance. Another benefit of equal weighted portfolio is that equal weighting results in broader sector participation. 

CONCLUSION:-

In an attempt to beat the markets, investors are so focused on identifying the right stocks that they ignore two of the most crucial aspects of portfolio management viz., portfolio weighting and investment horizon. No wealth will be created if an investor purchases a right share at right price but allocates minimal weight to the stock in the portfolio and sell the same share within a few months of purchasing it.

It is crucial to understand that a good share, when included in the portfolio, should be given enough time to generate returns. Most investors end up buying a right share at the right time, but selling it prematurely. 

All the three parameters such as portfolio stock selection and market timing, portfolio weighting and ability to stay invested for long-term will determine the portfolio returns in real sense over a period of time. Investor ought to give adequate weightage for all the three parameters in order to beat the markets consistently over a period of time. 

It is important that investors maintain a strategic perspective in an globalised investing world. Often, the most powerful investment ideas are simple ones. Choosing a standardised weighting option is unlikely to be the best weighting option for investors. However, if an investor is not sure of conviction stocks and is unsure of which stocks to be given higher weightages, then adopting an equal weightage strategy seems like a good strategy to adopt for beating the key benchmark indices such as Nifty and Sensex.

Ramnath Venkateswaran, Fund Manager — Equity, LIC MF

How important is portfolio weighting if one has to beat markets? 

Two important considerations for building a portfolio to outperform the broader indices over the longer term are : (1) Identify stocks with a high price appreciation potential compared to the overall market and (2) Have a significantly higher weight on these stocks compared to the potential laggards. Hence, portfolio weighting is a significant element of portfolio construction. 

As a fund manager, how to you decide on which stocks to give how much weightage? 

Portfolio construction at our firm is the culmination of the following steps: (1) Quantitative model to identify stocks; (2) Detailed review of the stock ideas from a fundamental perspective factoring in valuation parameters; (3) Drill-down to 30-40 stocks in the portfolio based on the philosophy of the fund. If it is a value-oriented fund, majority of the AUM will be in companies that can justify their market capitalisation within 3-4 years of normalised profitability. If it is a growth-oriented fund majority of the AUM will be in companies with high scalability and healthy return ratios. Weight to a particular stock is a function of: (1) Gap between the current price and what we perceive as ‘fair value' estimate of the underlying business assuming conservative projections; (2) Liquidity of the stock–a measure to check if we can exit the stock with minimal price disruption in case some of the underlying assumptions change. The individual weights to stocks is further assessed from a macro-perspective to check if we are taking too high a concentration on particular macro environment factors like interest rates, benign commodity prices, etc..

Is there any evidence that equal weightage portfolio can give investors an edge to outperform markets? 

There is no single portfolio or a magic formula that can outperform the markets consistently. It is up to the individual investor's risk appetite and his/her appreciation of risks. Wise investors have emphasised that maintaining a conservative approach of capital protection, adopting a clear-headed approach to benefit from volatility from markets is a good way to make money over the longer term.