They say that sometimes in stock market experience comes in more handful than mere knowledge and/or information. Similarly, an investor can get to learn & obtain more and more know-how about investing as he experiences a patch of lean period of action like current bear phase. And nothing better than the ongoing deep recessionary bear market across the globe. It teaches various lessons which may range from patience, perseverance, art of staggering investments, discipline in decision making and rationalization of expectations among various others.
Though, it is understood that, investors in stock markets have short and weak memory. Most of the times, they do learn quickly from their past mistakes. But, as soon as times of recovery re-emerge on the horizon along with the waves of over-exuberance, they tend to forget about the past experience and fail to implement the lessons of the bad times thus depicting lack of discipline & perseverance.
Diversifying Fruitfully:
Every kind of asset class is fraught with uncertainty upto a certain extent. No investment is a sure shot guarantee of fixed returns. This aspect of uncertainty in offering returns makes the world of investment diverse and broad in nature depending upon its return and risk profile. This very quality of uniqueness in providing diverse returns is useful to determine & examine various options from the number of different asset class based on one’s investment and risk profile.
Diversification - to explain it in simple language, suppose there are 2 baskets full of fruits. One of them consists of only five Apples. The other one is filled with Mango, Apple, Grapes, Orange and Banana. Thus, both the baskets are filled with 5 units of fruits each – one with only Apples & other with mixed fruits. Which basket would you choose from? The one filled with only Apples or the one with the mixed basket of fruits?
The answer would be simple- any rational person would choose a mixed fruit basket simply because it contains of various different fruits. The person would get bored and would not like to eat 5 Apples at a time from the first basket. It may also be possible that the person may not have a liking towards the taste of Apple. In that case, he will have to remain hungry if he is awarded first basket filled with only Apples.
But, if the person is given the second basket, he may get to cherish different fruits with different taste and flavours. Even if the person does not have a liking towards a particular 1 or 2 specific fruits from the mixed fruit basket, he has the option to fill his stomach with remaining different varieties of fruits.
Diversification of Equity Portfolio:
Same is the correlation between the above example of mixed fruit basket and diversification of equity portfolio. Just as the person opting for the second basket of mixed fruit, who did not like 1 or 2 fruits even from the mixed fruit basket, could contain his hunger by consuming remaining varieties of fruits – even an investor could shield his portfolio performance and movement from the dominance of a particular stock(s)’ performance.
De-risking of Portfolio:
In equity markets, diversification is needed to de-risk the portfolio from the risks and uncertainty revolving around any specific company’s stock. Also, an under-diversified portfolio is vulnerable to movement & fluctuation of the limited number of constituent stocks in one’s kitty. The returns of an under-diversified portfolio could be affected negatively, if one of the major constituent in the portfolio witnesses any sort of setback or slowdown or even frauds as experienced recently by shareholders of Satyam Computers. This shows that even financially sound companies with good past management track record can also go down under or get stuck in trouble by any kind of fraud or mismanagement issues.
Going much deeper into the topic of diversification, one can also create and tweak diversification strategy depending upon one’s goals, objectives & risk profile. Diversification of an equity portfolio could be of two types:
1) Sector Allocation
2) Staggering by Time.
Sector Allocation:
This form of diversification relates to buying stake of companies operating in various different sectors and industries. This form of diversification shields one’s portfolio from the exposure and risks related to performance and prospects of a particular sector of the industry. Many-a-times, particular business operations are exposed to performance according to the seasonal nature of markets. During such times, the performance of the company may get affected during the season period of lean operations or demand for their goods or services.
Why is Sector Diversification needed?
Sector wise Diversification is needed in long-term investment as the investor is willing to wait & hold the portfolio for a longer-duration of time or until his pre-set targets are achieved. This long-term investment can span across few years or even more. During such times, in this constantly changing environment, various sector of the economy come into bullish TREND & diminish from the buzz due to various factors like seasonality, slowdown, etc. The trend keeps changing among various sectors depending upon various internal and/or external conditions related to the economy in general.
Like, for example, at one point of time, IT sector was doing very well. But with recent recessionary environment in US, it is more likely that even the IT sector may witness a slowing demand for their services as their clients tighten their fist to curtail & control expenses. Thus the IT sector was prone to external environmental conditions prevailing in overseas markets.
Examples of Sector Diversification:
1) Highlights of Defensive stocks: Let us take another example, currently in the ongoing bear phase, FMCG sector has shown better resilience to downturn due to their nature of dealing in the space of inevitable fast-moving consumer goods which may be needed in daily sustenance of life. At the most, consumers may opt to stop using expensive soaps and switch to cheaper soaps, but they won’t absolutely stop using them in their routine life. Same logic goes for Pharmaceutical sector, where people won’t stop consuming medicines even in a bearish and slowing market conditions.
But, in the last bull phase, the above mentioned so-called ‘Defensive stocks’ had under-performed markets based on their nature of slow & steady growth based on routine consumer demand. Markets do not correlate such defensive stocks with bright prospects as in ‘Growth’ stocks. This leads to under-performance of stocks from defensive sectors during bull phases & out-performance during periods of pessimism when defensive sectors are awarded for their dealing in the space of steady business operations.
2) Highlights of Growth stocks: On the other hand, during the last bull phase, we witnessed sharp rallies in stocks related with Commodity businesses, like for example Metals, Crude, etc. on the back of thinking of investors and analysts that these natural resources are up for extinction in the global markets and thus ripe for demand-supply mismatch.
Thus, for an investor with long-term horizon, needs to have stocks from various different sectors so as to ably float through all different business cycles & phases with some degree of cushion strength. If the investor has some stocks from FMCG sector, it would help him to ride through the volatility of bear phase.
Based on above discussion, it could be implied that every portfolio should have around 10-20% investment in DEFENSIVE sector stocks to over-come the over-aggressiveness of remaining sectors. This would provide cushion of safety when the tide turns in opposite direction, as we witnessing right now – in the current bear phase.
Staggering by Time:
Staggering by time is nothing but spreading one’s investments over a period of time in a strategic manner. This strategy helps in curtailing concentration of investments in a short span of time & thus proves a shield by not endangering the investors to the vagaries of market movement in a specific short-term period.
Like for example, many new investors plunged into stocks markets when the indices started coming-off from its peaks recorded a little more than a year ago. When indices started to slump from Sensex 21000 levels and reached 16000 levels, many investors felt it is an opportunity to invest money at lower levels. A large number of people would have invested at such lower levels as well. And it was quite understandable, at that time- based on fundamentals then, that investors sitting on cash would have invested then.
But, what would have happened such investors would have invested all their life’s savings specifically at 16000 levels?
As we know markets plunged further to establish even lower levels to date, these investors would have run out of money had they opted to invest most of their idle funds at higher levels of Sensex16000. Those who would have used the strategy of staggering the investment of their funds at different point of time intervals, would have benefited in spreading their investments in a thin manner at even lower levels, say, at an interval of every 3 months.
You can read more on my detailed views on the approach of Staggering by Time in my first ever posting in this blog with the title ‘Strategy for Investment’.
Sector Allocation Guide:
Given below are various different Sectors in which investors can diversify their funds to de-risk through Sector Allocation strategy:
Core Sector:
Capital Goods & Engineering: 15-20%
Power & Energy Sector: 14-18%
Banking & NBFC: 12-16%
Oil & Gas Sector: 12-14%
Telecom Sector: 8-12%
Non-Core Sectors:
Real Estate & Construction: 8-10%
Information Technology: 7-10%
Pharmaceutical & Healthcare: 5-8%
Automobile Sector: 6-8%
Media & Entertainment: 6-8%
FMCG Sector: 4-6%
Metals: 6-8%
The above is one such presentation of diversifying an equity portfolio based on strategy of Sector allocation. The above does not mean to imply that one must be invested in the entire list of above sector. One can opt for any 6-8 sectors from the above list.
However, it would be preferable if one has some sort of mandatory investments in the all the first 5 sectors of Capital Goods, Banking, Telecom, Power & Oil and Gas. It’s like a Core Sector group. From the remaining list of Non-core sector, one can opt for any 3-4 sectors depending upon one’s likes & dislikes.
Diversification by Market Capitalization:
Another way of looking at Equity portfolio diversification is determining on the basis of a stock’s market capitalization levels– Large cap, Mid-cap and Small cap.
Large cap Stock: Market cap of above Rs.5000 cr.
Mid cap Stock: Market cap in the range of Rs.500 cr to 5000 cr.
Small cap Stock: Market cap of below Rs.500 cr.
Though, this does not exactly specify the rule for determining the market cap of all companies. In bull phase, most of the mid-cap would have been valued at market cap of over Rs.5000 crore. But, in the current bear scenario, not many mid-caps are able to survive above Rs.5000 crore. So, the above formula of determining stocks based on market capital is a highly ‘Relative’ guide. Though, this can be taken as a rough estimate in laying companies unique from each other based on market capitalization of these companies.
Usually, large caps are associated with safety & steadiness during such pessimistic times. On the other hand, mid & small caps are regarded as highly risky and fluctuating during such slowing times.
I would suggest investment in stocks based on market cap for various investors with varied RISK profile as follows:
Low risk Profile:
75-85% in Large caps.
15-25% in Mid caps
Nil in Small caps.
Medium Risk Profile:
65-75% in Large caps
25-35% in Mid caps
0-5% in Small caps
High Risk Profile:
45-60% in Large caps
40-55% in Mid caps
5-15% in Small caps
Correlating 'Sector Diversification' Strategy with my 'Favourite Stocks for Long-term Investment':
In my previous post, i had listed the list of my favourite stocks for long-term investment plans. Now, over here, i will correlate that portfolio with the above discussed strategy on 'Sector Allocation' for Diversifying portfolio:
(A) Core Sector:
Capital Goods & Engineering: 15-20%
Larsen & Toubro: 12%
Bhel: 4%
Thermax: 3%
Power & Energy Sector: 14-16%
NTPC: 5%
Power Grid: 5%
R.power: 3%
Suzlon: 3%
Banking & NBFC: 12-16%
State Bank of India: 6%
ICICI: 3%
R.Capital: 3%
Telecom Sector: 8-12%
R.Comm: 5%
OnMobile: 3%
Oil & Gas Sector: 12-14%
Reliance Industries: 13%
(B) Non-Core Sectors:
Real Estate & Construction: 7-10%
DLF: 4%
HCC: 3%
Information Technology: 7-10%
TCS: 4%
Financial Tech: 3%
Pharmaceutical & Healthcare: 5-8%
Ranbaxy: 3%
Biocon: 3%
FMCG Sector: 4-6%
ITC: 5%
Metals: 6-8%
Sterlite Ind: 4%
Sesa Goa: 3%
Total = 100%
Portfolio Features of the above presentation:
In the above Analysis of Portfolio coupled with Sector Allocation, I have tried to encompass sector diversification at its best to my knowledge. The above portfolio constitutes of Large Caps to the extent of 72% of the portfolio & 28% reliance on Mid-cap stocks, thus favouring Low risk to medium risk investors both. Readers can carry out minor adjustments to the portfolio to suit exactly to their risk profile by few nothces up or down.
11% of the above portfolio is formed of Defensive sector stocks like FMCG and Pharma that shall be useful to shield the investor from the sharp fluctuations and vagaries of the market. 'Core' sectors like Capital Goods & Engineering, Power & Energy, Banking & finance, Telecom and Oil & Gas Sectors constitute 68% of the over portfolio leaving the remaining space for the non-core portfolio sectors.
Portfolio Summary on Sector Allocation:
1) The portfolio constitutes of balanced number of 22 stocks.
2) Large caps: 72%, Mid caps: 28%
3) Core Sectors: 68%, Non-core Sector: 32%
4) Defensive Sector: 11%
5) Reliance + L&T = 25% of portfolio
6) My Core Portfolio Stocks = 50% of portfolio
(Reliance, L&T, SBI, NTPC, PGCIL, RComm, Bhel)
A Request to Readers:
Readers are requested to share their experience with this posting which has integrated stocks discussed in previous topic along with strategies needed for its better implementation to arrive at a balanced portfolio for long-term investment Readers can share their views in the below given 'Comments' Section.
Disclaimer: All data, content and/or reports posted by Viral Rajnikant Dholakia on this site are only for information and educational purpose of visitor/readers of this blog. It does not constitute to be a recommendation/offer/advice to buy or sell assets/securities in any form. Individuals/organizations are requested to take an informed call by consulting their Financial Advisor before acting on any matter/data published on this blog. This blog does not warrant of any kind of accuracy, adequacy and completeness of data, ideas or thoughts published in it. This site and Viral Rajnikant Dholakia assumes no responsibility or liability or loss or damage of any nature for your trading and investment decisions and its consequent results.
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