Do not put all eggs in one basket – so goes an old investment saying. While aiming for rewards, risks need to be managed too. Diversifying risks with a portfolio is what all of us (including the big fund managers) do but there are few aspects (learned hard way) which help us get make portfolio perform better.
Portfolio theory is as old as investment theory itself. I am not intending to change anything there but I would like to touch upon practical aspects and some of the best practices to follow while building and managing a portfolio.
1. Having unrelated stocks in the portfolio: Let us say you already have a bank stock. Adding one more bank stock to your portfolio, though it is a separate company, would increase the exposure to same sector. When there are policy impacts, all banks tend to react in a same way at least in direction if not in magnitude. Similarly investing in related sectors like steel and coal (where in one sector feeds the other so have a stronger correlation) need to be avoided. They fail the purpose of diversification as risk concentration still remains high. Do your research and understand how those companies run businesses before you commit funds. Ensure concentration in any stock or sector is no more than 20%.
2. Avoiding fully invested strategy: When market goes down due to some crisis, all stocks tend to go down. If you are fully invested you cannot make use of the opportunity. When your portfolio has done well and if you have booked profits, you do not have to invest that money quickly. Staying on cash helps when unforeseen event strikes (which cannot be predicted) or when there routine-technical down cycles. Cash or equivalent liquid holdings can be 20% to 50% of your portfolio. That way when the down cycle runs for months, you will not run out of money to invest. When everyone loses hope, stock valuations will be great and you should not be in a position of not having money to invest.
3. Too much diversification is difficult to manage: It would be ideal to have 5-6 stocks in your portfolio at a time and probably few more on your investment radar but without funds committed. Unless it is your full time job, it would be difficult to track more than handful stocks at a time. It is better to get to know the stocks well, and if some stock gives you a miss, better cut it off completely and move on. We need to keep the pipeline full to ensure we would not run out of ideas when the current investments either saturate or gives us a miss.
4. Use fundamentals while choosing the stock and technical to time entry and exit: Before committing funds one has to ensure whole of the story is good. Lower P/E ratio and higher earnings growth is what one should ensure. Higher P/E stock would mean it has already got attention of the market, only way it can increase its value is by expanding its earning. If earning gives a miss, this stock will become a double edged sword as P/E multiple will shrink too. It is a risky proportion. At the same time, investing in low P/E but higher earnings growth potential is like turbo-boosting your investment. First earnings will grow so will be the stock price, then P/E multiple will expand attracting market attention taking the stock to expensive valuation giving you an exit point. Identifying such stocks is a very tedious task but it is worth the effort. You need to read in between those financial statements, understand products, customers, competitors to the level of those running those companies understand them and also run your own checks (such as visiting the project locations, seeing things first hand etc.) apart from scanning publicly available information. This demands good time and involvement of yours. So I say limit the number of stocks you invest in. Selecting the right stock is half job done.
The other half of the job involves identifying the entry points, holding period and the exit points. Technical analysis such as moving averages, support-resistances in chart trend patterns, candle stick charts for identifying top or bottoms and trend reversals can help a lot. F&O data too can act as a verification measure for your expectation. But remember, no matter how much effort you put in, technical analysis does not guarantee success. Since you have put money in fundamentally good stock, your risks are limited if technical analysis does not work for you. And staying on cash helps you to rectify mistakes if you did not get it right. Technical analysis is to maximize returns by getting to know the relatively short term acts better but should not be the criteria for stock selection.
Summary: While above the pointers help, it takes many years of practice to make it really work for you. One should have realistic expectations on the portfolio performance too. Remember, lower the risk, lower is the reward. Riskier portfolio and strategies depend a lot on the luck, they earn run away profits sometime but it cannot be repeated so not sustainable over long period. The first objective in investment is to minimize the risks and the second priority is to pocket the profits. This way your investments will have a longer life when things do not go right.
Risking life to score few extra points may not be the best thing to do always. Ditto applies to the investment world too.
(Disclaimer: This article can make a good investor a better one but cannot turn a bad investor into a good one)