Diversify stock portfolio to curtail investment risks

The latest market volatility has spooked many investors including some of the seasoned professionals. The reasons could be many - the increase of tax surcharge on Foreign Portfolio Investment (FPI) and the proposed changes in proportion of public float in listed entities, etc. But what one is experiencing is the meltdown of stock markets and the erosion of value in their portfolios. This is primarily because of the lack of diversification and improper asset allocation.

Stock markets exhibit cyclical behaviour with rotation of certain sectors in each of these cycles which could also match or overlap the industry cycle. For instance, steel or other metal sectors tend to have a 10-year cycle while automobile sector generally has an eight-year cycle.

The stock markets also reflect these cycles by displaying the boom to bust cycle of stocks of these sectors and mostly forward price them. So, if investors had taken exposures mainly in certain sectors as they were the performing lot, they would have now accumulated losses due to the cyclical underperformance.

The only way to beat the concentration risk is through diversification. The more the concentration, the higher the risk though that also provides for a higher superior return. For instance, if an investor owns just two to three stocks in his portfolio and these stocks do well, the returns would be exponential so is the case during the losses.

Arguably, one of the greatest value investors of our times, Warren Buffet himself has said that, 'diversification is protection against ignorance. It makes little sense if you know what you are doing'.

And his buddy Munger has to say this: 'The whole idea of diversification when you are looking for excellence is totally ridiculous. It does not work. It gives you an impossible task.' So is diversification for idiots? - as Mark Cuban once quoted.

Unfortunately, many misunderstand diversification as just spreading of risk or exposing across various types of assets. The catch here is the correlation i.e. the less correlated each of the assets in the portfolio, the better is the diversification.

When a portfolio is highly concentrated, the returns should be highly exceptional to recover the loss if any happened. Drawdowns i.e. losses or falls in the stock market are part of the game and volatility in the prices cause upheaval to recover from the earlier losses.

For example, if there is a 10 per cent drawdown in the portfolio then the return required to bounce back is 11 per cent and for a 30 per cent drawdown the return to recovery is 43 per cent. For a loss of 50 per cent, then the bounce back needed is 100 per cent return and in an extreme event of a 90 per cent drawdown then 900 per cent return is needed to bounce back.

This means, the sharper the drawdown, the higher the bounce back needed. So, its difficult to achieve these kinds of returns especially after such falls and hence concentration is a double-edged sword.

In a downturn, it not only nationalises the losses but also needs extraordinary returns to just to cover these losses. As an investor, one need not always be looking at making returns but also should guard against blowups that impair the capital altogether.

Is there an ideal size of a portfolio that could achieve proper diversification when investing in stocks? Ben Graham, the legendary investor suggests a portfolio size of 20-30 stocks is an ideal approach and research also suggests the same. Sharpe ratio, a measure that assesses the risk-to-reward ratio in a portfolio tend to be maximised at about 25 positions in a stock portfolio.

Also, studies suggest that the overall market drawdown is possibly beaten only after the first 15 positions in the portfolio. Of course, the reward or risk is again dependent upon the weightage ascertained to the individual stocks within the portfolio.

The above mentioned is considering an equal weightage, remember here the assessment is based on the risk and return is always an outcome of risk management. One can't always design a portfolio with a targeted return but most likely achieve a targeted risk.

Concentrated portfolios could create wonders when successful but the maximum drawdown of 90 per cent is also a possibility. Not always could we end up owning the best of the stocks. Moreover, despite the short-term spikes in returns and the notional wealth a single stock portfolio delivers a similar return to that of all others in the long-run.

(The author is a co-founder of 'Wealocity', a wealth management firm and could be reached at knk@wealocity.com)