Strategies for constructing your portfolio

Narrow portfolio or broad portfolio? There are strong supporters of either strategy. The Efficient Market Theorists suggest that a broad portfolio that mimics market action is the best. In an efficient market, it’s very difficult to beat the indices. In the long run, equities as an asset class beat other asset classes so just lock in the market return. The index fund/ETF is based on this logic

On the other hand, some stocks will always be outperformers. If you can pick those, you can beat the market. This is, of course, what the active investor tries to do. However, it’s equally true that some stocks will always be underperformers. If a narrow stock-selection method doesn’t work, a poorly constructed narrow portfolio will underperform. So, using a narrow portfolio strategy involves more in the way of discrimination and also, undoubtedly, luck.

In practical terms, if you’re holding a narrow, concentrated portfolio, it’s easier to track those businesses. But there is an element of gambling involved – you will not get the market return; you will either beat the market or underperform it.

Another question on which opinion is divided is that of diversification across industries. A portfolio of 10 stocks spread across 10 different sectors has much more diversification than another portfolio of say, 30 stocks spread across five sectors. Some investors prefer to focus on a very small range of industries which they study intensively. Others don’t mind a spread across many industries, while restricting themselves to only studying the market leaders in each sector.

A highly diversified portfolio carries more safety than one with a narrow focus. There are very few industries that don’t possess cyclical characteristics. A diversified portfolio evens out that cyclicality. Of course, this will tend to bring the return back closer to the overall market return. Clever portfolio construction, with due attention paid to cross correlations and relative sector exposure, can help to reduce the risks somewhat without reducing the returns that much.

Clearly, any of these strategies can work. Some investors have been spectacularly and consistently successful while holding narrow-focus portfolios with very few stocks. Others have been successful by creating broader sector diversification, while only holding a few stocks in each sector. Still others have tended to the shotgun approach, where they buy every stock in given sectors.

The one thing that doesn’t make sense for an active investor is creating a broadly diversified portfolio with multiple stocks. Such a strategy will end up mimicking market returns and all the headache of analysis and selection can be dispensed with, by buying diversified equity funds instead. Unfortunately, this is precisely what happens to most buy-and-hold investors. They may start with a narrow focus and hold only a few stocks. Then, the market cycle changes and they buy some more stocks that promise to be outperformers. They repeat this process many times. Since they never sell, they end up holding many stocks across sectors.

There’s no formulaic solution for this. But consistent benchmarking and tracking portfolio correlation versus indices and cross-correlation between portfolio components can help avoid this trap. Such calculations can be done mechanically and it should be done, at regular intervals.

The author is a technical and equity analyst