Portfolio Construction: Part 1

Your returns are a function of both the asset you pick and the size of the asset in your portfolio

The wealth that you create is a function of both the asset/security you pick and weightage you give it in your portfolio. So, constructing a portfolio is (as important if not) more important than picking stocks to put inside your portfolio. This is because a stock that returns 100% in a year will add more wealth if it has a weightage of 20% and not 5%. But, in a lot of ways picking a stock is a lot easier when compared to sizing your position. You pick a stock based on your understanding of the business, but your size your position depending on the role that you want that stock to play in your portfolio. The size of your position also reflects the confidence you have in your investment thesis about a certain company. So, as a portfolio manager (all of us are managers) it is very important to construct your portfolio right to derive the maximum out of the investment thesis that you have constructed for a company.

There are only two ways to construct a portfolio either do a top down or do a bottom up. Different managers have different styles, but I more often than not lean towards the bottom-up style because of the “illusion of control” it offers. Your decision would be driven primarily by a stock – where the number of variables to size-up is limited – and not the macros – where the number of variables to control/factor in is higher. Constructing/re-balancing your portfolio based on the market conditions or your risk preferences could be an exasperating exercise but if you keep reminding yourself that the end goal is always to maximize returns then the probability of focusing on what is important increases. So, I’ve always found it easier to size your position based on the conviction in your investment thesis about a stock than your conviction about how the economic or sectoral macros shape up. It’s a lot easier to stick with a company that is fundamentally strong than to try and re-balance your portfolio in accordance with the movement in the economic or sectoral macros. I’ve always seen that if a company is fundamentally strong it would be able to weather sectoral & macro headwinds more successfully unless the headwinds aren’t structural or permanent. If headwinds are “structural” then all bets are off.

So, keeping all of this in mind I’ll take you on a step-by-step process to construct a portfolio right from security selection to security weighting and pointers on periodic re-balancing if and when required.

Stay tuned!

Disclaimer : I am not a SEBI registered investment analyst; none of the securities discussed here are investment recommendations; the views expressed are my own and are not that of my employer or their associates; I can not endorse the veracity of the data that I have pulled out from databases