Portfolio design should be apt for the investment strategy
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Most investors are aware that they need an investment strategy or at least a stock selection process. They spend a lot of time, effort and resources in understanding the intricacies of picking stocks. But which processes are better and which are worse is not the focus of this article. The question we want to address is: is your portfolio design appropriate for your investment strategy?
Once an investor has chosen an investment strategy and the related stock selection procedure, the portfolio design is an ad hoc result of her buying, selling and holding decisions. Often, when investors are sitting on large cash reserves or the markets are looking exciting and moving up quickly, and a stock makes it through their stock selection process, they allocate a large amount of capital to it. When the markets are more subdued or they have smaller cash reserves, at that time, they may allocate a smaller amount of capital to the stock. Hardly any thought is spared to portfolio construction. It is more a result of a number of unrelated decisions over a period of time rather than a well-thought out design with the goal of managing certain risks.
So why and how does one look at portfolio design? For each strategy, there are two things that have to be established. First, what is the probability that your pick is successful? Second, when it is successful, what kind of percentage return it provides, and when it fails, what is the size of the percentage loss?
For example, a high-risk, high-return strategy, say, one akin to venture capital, would have a low probability of success, but when an investment is successful, it gives extraordinarily high returns of 10 times to 100 times or more. And when most of the investments fail, they fail with nearly all the capital gone or substantial capital erosion. In this case, it is critical that the portfolio has a large number of small positions to increase the chances of catching that single investment. If that successful investment is missing from the portfolio, since it is too concentrated, this strategy will result in zero returns and a substantial loss of capital. The correct portfolio design for such a strategy is to have a large number of positions such that the chances of at least one of them giving extraordinary success, is high.
Now suppose the approach is such that investments come sequentially. For example, investing in all IPOs for listing gains. In this case, there could be stocks that will not have listing gains or one might not be able to liquidate their position at a high price during the first few days of listing. The money invested is going to be stuck for quite some time, until the stock goes into profits again; or one accepts the losses and exits with reduced capital. For such a strategy, if the investor puts all her investable capital into one IPO and then that IPO is the one that results in listing being below the IPO price, one has lost a certain percentage of capital. To handle this risk, the portfolio design should be such that one invests, say, not more than 10-20% in any given IPO at a time, even if it means that the remaining 80-90% of the money is lying idle. Doing so gives you a chance to participate in future IPOs, even if the first one doesn’t go as expected. The investor can invest sequentially in each IPO, and exit with listing gains. Each successful exit will enhance the capital and each failed IPO investment will still not reduce the portfolio to such an extent that the investor can no longer participate in future IPOs. Moving on to a strategy of buying fast-growing companies. Many of these companies are favourites of the markets and, hence, extremely expensive in terms of valuations. The portfolio design should incorporate the view that since these stocks are priced to perfection, any hiccup due to internal or external risks can cause a sudden drop in prices. So an ultra-concentrated portfolio, say, of only 3-5 stocks, could result in a sharp drop in the portfolio value if anything goes wrong with even one stock. If the same portfolio held about 10 such companies, then the chances of a steep drop is reduced. One should also ensure that all the companies are not from the same sector. Some people invest in turnarounds, typically leveraged companies facing operational difficulties. In this case, too, one should make sure that there are a large number of companies in the portfolio since one is not sure about which companies are going to turnaround in what time frame and which are likely to deteriorate, possibly irreversibly.
Depending on what one expects in terms of success rate and payoff, one should have enough companies so that the investment works out at the portfolio level, even if any individual company goes bust. This strategy has lot of similarities with junk bond investing or cigar-butt investing. For low-risk strategies with high probability of a successful stock pick, one can have a relatively concentrated portfolio. But with high-risk strategies with low probability of a successful stock pick— where the successful pick gives extraordinary returns—one can have a diversified portfolio. The approach to portfolio design requires deep thinking and information gathering as to the success rates and expected returns and losses from each pick. Investing is fun, but no one said it is easy.
Vikas Gupta is CEO & chief investment strategist, OmniScience Capital