Best Way to Build Portfolio - Diversification or Concentration
Diversification
How to Diversify a Portfolio
Since many investors aim to beat the market, they may wish to revisit the issue of diversification versus concentration in their portfolio choices.
There are several ways to attain diversification. One way is that the investor could diversify his investments among several different companies. It is also possible to diversify among various sectors. Owning stock in both a technology firm and an energy company provides more diversification than simply owning two tech stocks.
More diversification can be achieved by investing in companies with varying market capitalizations. Returns are often different for small-cap stocks and large-cap stocks. Portfolio diversification can also be obtained by investing in foreign companies instead of just domestic firms. Pursuing different strategies, such as growth or value investing, also provides diversification.
The highest level of diversification can be achieved by investing in different asset classes. Bonds are far less volatile than stocks, and government bonds often go up in price when stocks go down. Commodities are another significant asset class with a different pattern of returns. Finally, buying and selling options on stocks, commodities, and other assets provides even more diversification.
The real question is to what extent investors should diversify their portfolios. The answer depends on personal goals, risk tolerance, and preferred investment strategies. Investors should consider the relative advantages and disadvantages of diversification within a personalized framework.
Advantages of a Diversified Portfolio
Diversification reduces an investor's overall level of volatility and potential risk. When investments in one area perform poorly, other investments in the portfolio can offset losses. That is particularly true when investors hold assets that are negatively correlated.
An investor who chooses to diversify with investments in foreign stocks can try to put funds into countries experiencing economic booms. Those shares can produce substantial gains at a time when the performance of domestic stocks is mediocre to poor.
Disadvantages of Increasing Diversification
The problems with diversification are less publicized, and therefore less well known. The truth is that diversification can also have adverse effects on an investment portfolio. Diversifying an investment portfolio tends to limit potential gains and produce average results. An investment portfolio of five carefully chosen stocks can substantially outperform the market. Watering it down with dozens of other stocks leads to mediocre performance.
Another problem with aiming for broad diversification is that it may require extra work to rebalance your portfolio. A widely diversified portfolio with a lot of different holdings is generally more trouble to monitor and adjust since the investor has to stay on top of many investments. Diversification can even increase risk if trying to diversify leads an investor to become careless. In many cases, investors seeking high levels of diversification are better off with mutual funds or exchange-traded funds (ETFs).
Concentration Strategy
Concentration or portfolio concentration is an important element of investing and has a great impact on investment returns. Portfolio concentration means that the investment portfolio has a select number of positions and there is not an abundance of investment positions, and there is not wide diversification and each position tends to be a larger percentage of the fund or portfolio.
Investors with a concentrated strategy have the potential to generate portfolio gains greater than general market averages. With a focus on fewer but high-quality companies, concentrated portfolios allow the investor the opportunity to become very familiar with their holdings, managing them more productively and energetically.
Concentrated portfolios can capture more market returns than broadly diversified portfolios because there are stronger equity positions in durable, industry-leading companies, increasing the probability of better portfolio performance.
On the flip side, a concentrated portfolio can suffer if investors don't pick the right companies. Investors must exhibit the ability to choose a stock that has the potential for long-term sustainability – only by having a strict set of guidelines when selecting stocks can you attempt to beat the market, a process that takes time and dedication.
A concentrated strategy may have more potential for capital gains, but it's more difficult to implement a concentrated portfolio successfully. Competing in this space demands more resources like capital, market research and access.
Advantages of Concentrated Portfolios
One of the benefits of a more concentrated portfolio is that while it does increase risk, it also increases potential gains. Investment portfolios that obtain the highest returns for investors are not usually widely diversified. Those with investments concentrated in a few companies or industries are better at building vast wealth.
A more concentrated portfolio also enables investors to focus on a manageable number of high-quality investments
The best path for an investor may be to aim for only a modest amount of diversity while primarily focusing on selecting high-quality investments. These investments should be chosen using a preferred investment strategy, such as growth investing, income investing, or value investing. Personal risk tolerance and overall investment goals are also important.
While some level of diversification should be a consideration in constructing an investment portfolio, it should not be the driving concern. The primary focus of an investment portfolio should always be meeting the personal goals and financial needs of the individual investor.
How many stocks should I choose for investment?
The answer to this question according to some analysts is that for a portfolio, maximum ten to fifteen stocks are enough for diversification.
In a book by Benjamin Graham, the “Intelligent Investor”, he has mentioned that one can build a perfectly diversified equity portfolio with 10 to 30 stocks. However, the number of stocks in one’s portfolio is not about “random investing”.
Equity investment is anything but random investing. Everyone has their styles of investing and hence need to choose the stocks according to his risk appetite and sector preference. For example, an aggressive investor may opt for growth stocks while a sector biased person might opt for a heavy exposure in a particular sector.
The truth is that there is no one size fits all solution and many factors need to be taken into account to arrive at the ideal number of stocks in your portfolio.
Investors should consider factors like their tolerance to risk, research capability and bandwidth, the time horizon of investment, the importance of cash buffer, etc.
How to Pick a Stock?
So now the investor has finally decided to start investing. He already knows that a low P/E ratio is generally better than a high P/E ratio, that a company with a lot of cash on its balance sheet is superior to one burdened with debt, and that analysts' recommendations should always be taken with a grain of salt. And he knows the cardinal rule of the smart investor: A portfolio should be diversified across multiple sectors.
That pretty much covers the basics, whether or not he has waded through the more complicated concepts of technical analysis. We are now ready to pick stocks.
With tens of thousands of stocks to choose from, how do he go about selecting a few worth buying? Whatever some experts suggest, it's just not possible to comb through every balance sheet to identify companies that have a favourable net debt position and are improving their net margins. A stock screener is prone to error. Riding the coattails of institutional investors is an option, but they tend to rely on safe blue-chip stocks that may or may not provide the best returns.
Certain sectors perform better than others, so if the market is heading higher, we want to buy stocks within sectors that are performing the best. In other words, we want to invest in sectors that are outperforming the overall market. For example, the technology sector might be up 10% versus a 3% rise in the overall market, as measured by a benchmark such as the S&P 500 index.
By analysing several time frames, we can pick the hottest sectors that are not just performing well right now but have been showing strength over a longer period. The time frames that investors choose will depend on their investment time horizon. Next, we choose the sector that is one of the top-performing sectors. Investors can choose a few of the top sectors to create diversification.
We can also view the chart of an exchange-traded fund (ETF) for a particular sector. The ETF would contain a basket of securities that track the stocks within a sector. The trend should be defined by a trendline, with the ETF showing strength as it rises off the line. The trendline merely connects all of the higher lows in an uptrend (or the low points in the corrections). In an uptrend, each correction low should touch the upward sloping trendline. If the trend is continuing, there should be a bounce off the trendline and in the direction of the trend.
Once we've identified an uptrend in a sector that's outperforming the market, we need to identify the stocks within the sector to buy. We could simply buy a basket of stocks reflecting the entire sector, which could perform reasonably well. However, we can do better by cherry-picking the best stocks within that sector. Just because a sector is moving higher does not mean that all of the stocks within that sector will be great performers. However, it's likely a few of those stocks will outperform, and those are the ones we want in our portfolio.
The process for identifying individual stocks is the same as the process for sector analysis. Within each sector, identify the stocks that have the greatest price appreciation using multiple timeframes to be sure that the stock is performing well over time. The stocks that have performed the best over two or three timeframes are the stocks we want. Examine the charts of the top performers and place trend lines on the chart whereby the price trend should be clearly defined. Profit objectives based on chart patterns should be established to identify potential price gains while also considering the risk of losses.
Of course, there's no guarantee that even after following these steps an investor will make extraordinary returns, but this strategy does offer the chance to earn better-than-market returns. Some monitoring of positions is required to make sure the sectors and stocks are still in favour with the market. Also, be aware of overtrading, which can result in excessive commissions; this why we use multiple timeframes.
If one’s stocks or sectors begin to fall out of favour across the multiple timeframes, it's time to rotate into the sectors that are performing well–a process called sector rotation. The market analysis should guide the investor when to exit positions. When major trend lines within the stocks being held, or sectors being watched, are broken, it's time to exit and look for new trade candidates.
This strategy does require some turnover of trades, as sectors and the leading stocks within those sectors will change over time. The object is to be in stocks that are leading the market higher in bull markets, and if you are not opposed to short selling, being short in the weakest stocks that are leading the market lower during bear markets. We do this by finding the hottest sectors (for a bull market) over a period of time and identify the best-performing stocks within that sector. By continually transferring assets into the best-performing stocks, we stand a good chance to make above-average returns.
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