4 Reasons to build a Stock Portfolio – Share Market Basics for New Investors
4 Reasons to build a Stock Portfolio is the latest in the series of articles in ‘Share market basics for new investors’. This series is written to explain the basic fundamentals of the share market. In these articles, we talk about the “street smart” knowledge investors need to be successful.
Prior articles in this series are Diversification can be a trap and Investing is not gambling.
Introduction
A ‘Stock Portfolio’ sounds complicated and technical. However, it is simply a collection of stocks that you own – all that matters about your stock portfolio is which stock you own and how much. When you own a stock portfolio instead of just one individual stock, it provides some stability to the total return generated by your investment. It is likely that if one stock you own goes down, there may be another that goes up.
Benefits of Building a Share Portfolio
Harry Markowitz introduced the idea of the Modern Portfolio Theory in 1952. His article called “Portfolio Selection” was first published in the Journal of Finance. It is one of the most influential economic theories dealing with finance and investment.
MPT says by investing in more than one stock, an investor can reap the benefits of diversification – chief among them, a reduction in the riskiness of the portfolio.
The key phrase is ‘reduction of risk due to diversification’.
Let’s look at how diversification reduces the risk and on the flip side what you give up due to diversification.
Building a Strong Stock Portfolio is the key to financial success
What does ‘reduction of risk due to diversification’ mean?
There are several types of risks that an investor has to deal with while investing in stocks. Some risks are such that they impact many companies. For example, if the rubber price goes up, it impacts all tyre companies. If the crude oil price goes up, it impacts all airlines. Then there are are risks that are very specific to a particular company. For example, if FDA initiates an investigation against Cipla, it will have an adverse effect just on Cipla. If SBI underperforms due to increasing non-performing assets, its impact will be limited just to SBI shares.
The risk that impacts a specific company or a specific sector is known as a non-systemic risk.
Diversification by investing in multiple companies reduces non-systemic risks, risks that are specific to a particular company or a sector.
For companies with good fundamentals, these risks are of temporary nature. As soon as the issues are resolved, the stock prices bounce back. Building a portfolio of good companies reduces the volatility created by such short term events.
Diversification reduces short term volatility. It doesn’t actually protect the investment from real (or bigger) risks. A portfolio doesn’t protect your investment from systemic risks or black swan events.
Regardless of the company size, its capitalization, its fundamentals, the industry it belongs to, each and every company has a positive correlation with the market. If the overall direction of the market is down, most companies will go down. In 2008 when the markets all over the world crashed, remember any stock that went up?
Building a share portfolio will not protect your investment in such cases.
Share portfolio is a bucket of liquid assets. Hence if you are in a need of cash, you can sell the shares of the company that is profitable at that time. If you have invested in just one company, and that stock is down, you will end up selling the shares at a loss. The portfolio gives you choices on what to sell. In most cases, investors do not need to sell their entire portfolio.
So what should be the size of an ideal portfolio? How many companies should one own? 10 companies? 20? 30??
In general, the more companies you have in your portfolio:
– The less volatile will be your overall portfolio
– The less probability your portfolio’s return will be above average
– The more time you will have to spend tracking these companies
This is assuming all stocks have more or less equal weight in your portfolio.
Contrary to popular belief, if you are new to investing, you should make small investments in many companies – even as less as 1 share if the stock price is high (e.g. Maruti stock is over Rs. 5000). As you get the hang of it, start reducing the number of companies in your portfolio. This process will give you the confidence to increase the concentration in the right companies for your portfolio.
While building the portfolio, it is critical to consider the duration for which you are building it. For example, if it is a 2-3 year portfolio, it may be a good idea to invest in cyclical industries like capital goods, or fertilizers. However, for a longer term portfolio of 10+ years, it may be a good idea to go with high growth but stable companies like HDFC, HDFC Bank, ITC etc.
You can build a stock portfolio by either buying shares of individual companies or by investing on equity mutual funds. In a future article, we will discuss the benefits of a a stock portfolio versus investing in mutual funds.
To summarise, the reasons to build a stock portfolio are –
1. Reduce non-systemic or company specific, and to some extend industry specific risks.
2. Reduce the volatility of your stock investment. Some losses will be offset by some gains.
3. If you have to generate cash, the portfolio of companies will give you options to sell shares. You can sell shares of companies where you have made a profit. Concentrated investments in a few companies do not give you that option.
4. Stock portfolios perform better than mutual funds, all things being equal.