How to build a stock portfolio

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With our equity product Prime Stocks going live a couple of weeks ago, seasoned stock investors among our subscribers have begun sifting through our recommended list of Buys and stocks on our Watchlist.

But we’re also seeing questions pouring in from folks who are new to the concept of owning stocks directly and have owned only mutual funds or other kinds of investments so far. 

If you’re new to stock investing or aren’t quite sure how our stock recommendations fit into your investment plans, we hope this article on constructing a stock portfolio will help you.

stock portfolio

If you’d like to approach portfolio construction scientifically, you should be reading the many standard academic volumes on the subject (check out the Wiley Finance series) which require some understanding of mathematics and statistics.

What we present here is simplified steps to construct an equity portfolio, that you can use even if you aren’t maths inclined.

# 1 Know your objectives

As with all other investments, it is best to start off on your stock investing journey with a clear picture of what you want to achieve.

Time frame: The first choice you need to make is on the time frame over which you expect returns. If you’re a fundamental investor, Prime Stock recommendations cater mainly to you. We strive to identify stocks that create wealth from earnings compounding that businesses are capable of. This is a process which takes time. You should therefore be investing with a minimum holding of five years in mind. The payoff period may sometimes be longer if you’re starting off in a raging bull market (like now!).

If you’re keen to earn returns quickly, trading in the cash or high-risk derivatives market may suit you better. You may like to use some of our articles on technical analysis like this one –

Return expectation: A second factor you need to have clarity on, is your return expectation. If you are content with a FD plus 2-3% return and wish for minimal monitoring, it can be achieved through our index fund recommendations or through our ETF recommendations. If you are a beginner, you can use our ready-to-use portfolios without ever picking up a book on portfolio construction or reading a balance sheet. Index funds are the easiest route you can take to owning equities. Most professional stock pickers struggle to beat the indices in the long run.

But if you are aiming for something more than FD-plus returns, aim for some serious wealth creation or leaving a legacy, a direct stock portfolio may fit the bill. Be aware though, that a direct stock portfolio also carries the risk of higher capital losses along with its promise of higher returns. Your direct equity holdings can be hurt more than MF holdings in a bear market as they are unlikely to be as diversified as your MF holdings. 

Effort: A third factor that should decide whether you need to add on a direct equity component is the amount of time you can devote to tracking and maintaining your portfolio and the efforts and skills you to bring to bear on understanding the drivers of a business. If you are short on both time and skills, a MF or index-based equity portfolio should be your choice rather than a direct stocks portfolio.  

# 2 Choose your style and strategy

Having decided to own a stock portfolio, a newbie mistake many make is to believe that all roads lead to Rome. They’re quite happy to accumulate stocks based on recommendations no matter where they get them – brokerage research reports, media calls, Whatsapp groups or even SMS tips from Indore-based ‘advisory’ firms.

But without clarity on the methodology, strategy and style you’d like to follow for portfolio construction, you will end up with a mish-mash portfolio that neither delivers on returns nor contains risks. 

Fundamental or technical analysis: The first call you’ll have to make is on whether you would like to follow fundamental or technical analysis to identify stocks. Fundamental investors believe that there’s scope to create wealth by identifying mispriced businesses that can compound earnings over time. Technical investors devote their attention wholly to a stock’s historical price movements and believe that everything that’s worth knowing about a company is already in the price. They buy stocks where the underlying trend is bullish and sell ones with a bearish trend. Typically, fundamental analysis is followed more by investors looking at longer horizons and technical analysis by those with shorter horizons, though there isn’t a hard and fast rule. Many seasoned investors use fundamentals to identify what stock to buy and deploy technicals to decide when to buy it. 

What we do: At PrimeInvestor, we follow a fundamental approach to picking stocks although we are conscious of identifying good price points to invest or to accumulate further.

Many new investors are tempted to skip the tricky decisions on style, strategy or timing, by simply hopping on to sidecar investing – blindly copying the stock moves of big-name billionaire investors. This is fraught with risk. A big-name investor may have a far higher capacity to take a capital loss than you do. He may have sources of income or wealth you have no idea about. He may limit risks through position sizing. He may disclose when he’s buying but not when he’s selling. 

Growth or value style: A second choice is between the value and growth styles of investing. The former looks to buy businesses that are trading at a discount to fair value, the latter buys businesses with potential for high growth, with less weightage to valuations. The value and growth styles outperform at different points in time in the market and it’s difficult to pinpoint which style will win. We suggest not being dogmatic and holding a mix of value and growth stocks in your portfolio. Owning some value stocks is particularly important in bull markets to contain downside.

What we do: We’ll strive to have a mix of growth and value picks in our buy list. Our investment thesis will help you understand the style each stock fits into.

Watchlist approach: To make sure that your portfolio ends up with prime businesses, we suggest taking a watchlist approach to stock-picking. Often, especially in bull markets that have run on for some time, you find good businesses that you understand and really like to own trading at very pricey valuations. Instead of going for a sub-par substitute or buying at an unaffordable price, put the stock on a personal wish list for closer tracking. Then use an event-triggered correction in the stock or a bear market to swoop in on it at a more attractive price.

What we do: We have created a watchlist of stocks that meet our basic filters and look prima facie investible.  We may move them to our buy list if they make the cut on specific business triggers or valuation. Not all of them will move to a buy. You may want to keep even some of our ‘buy candidates’ on your watchlist if you like many stocks in our list but aren’t able to buy them at once.

Many new investors are tempted to skip these tricky decisions on style, strategy or timing, by simply hopping on to sidecar investing – blindly copying the stock moves of big-name billionaire investors. This is fraught with risk. A big-name investor may have a far higher capacity to take a capital loss than you do. He may have sources of income or wealth you have no idea about. He may limit risks through position sizing. He may disclose when he’s buying but not when he’s selling.

# 3 Diversify

If you had a magic crystal ball to tell you that Infosys would deliver a 30% CAGR between 1995 and 2020, your best strategy to mint money from equities would have been to deploy your entire net worth in this single stock in 1995. But most of us aren’t blessed with a magic crystal ball and make stock choices that fail more often than succeed. This makes it essential for us to have diversified portfolio that spreads our bets, so that winners can compensate for any losers.

Apart from shielding against the possibility of going wrong with your stock choices, a diversified portfolio helps to smooth out your returns. Portfolio theory tells us that a well-diversified portfolio should be made up of assets that carry negative or at least low correlation with each other.

One way to ensure this is to have representation from many sectors without undue weights to one. While Indian indices feature fairly high weights in their top sectors (financials were 40% plus recently), we think you’d be better off restricting individual sector weights to 20-25%. Pay attention to owning sectors with different drivers. Banking stocks, being a play on India’s economic cycle, may not provide much of a diversification from infrastructure stocks or steel-makers. Consumer appliance stocks are unlikely to carry a negative correlation with FMCGs. For true sector diversification, strive for a balance of companies with domestic versus global revenues, cyclical versus defensive characteristics and secular versus volatile earnings.

Theory also argues for achieving diversification by sticking to pre-decided weights between large-cap, mid-cap and small-cap stocks. Large-cap stocks are believed to exhibit lower volatility than mid or small-caps. Therefore, if you’d like a portfolio with lower volatility, you can decide on a higher large-cap weight, with lower mid and small-cap weights.

While this is the textbook approach, remaining market-cap agnostic is not such a bad idea. A mid-cap company that is a market leader in a consumer-facing sector, with consistent margins and shareholder returns may be a better bet any day than an also-ran large-cap firm in a commodity business.  

Capping your weights to sectors or market caps is a good way to ensure that only your best ideas make it into your portfolio. You are forced to cull weak names from time to time, to stick to your pre-decided weights.

# 4 Pay attention to stock weights

If you take a research-based approach to stock selection, chances are that you will eventually get lucky with at least a few stocks turning multi-baggers over the years. But the regret that most of us nurse is investing peanuts in our really good picks and betting the house on dud stocks!  A well thought out strategy on position sizing can curb such regret. 

Traders use a position-sizing strategy based on their risk tolerance to decide on stock weights. When deciding on how much they will bet each time, they assess how much of their overall portfolio value they’re willing to lose in each trade. If a trader with a Rs 10 lakh portfolio is willing to lose no more than Rs 10,000 in a single trade, his position size would automatically be 1%. You could follow this approach and set up an equal weight long-term portfolio.

But you can also approach individual stock weights in two other ways. One, you can decide on your portfolio weights based on a stock’s historical risk-reward characteristics. Data on stocks’ historical returns as well volatility measures such as standard deviation are publicly available. If you would like a low risk-moderate return portfolio, you can have higher weights in stocks with low volatility (standard deviation or variance) and lower weights in those with higher volatility. Two, using a more qualitative approach, you can also have higher weights in stocks where you carry a better understanding of the business or higher conviction owing to reasonable valuations.

Studies suggest holding anywhere between 12 and 30 stocks in your portfolio delivers adequate diversification, which means a 3% to 8% weight per stock. You could also set a band for your individual stock weights based on the downside you can take (a 10% weight means that a 50% decline in price can hurt your portfolio by 5%). 

When buying stocks in bull markets, it is best to start small (say with a 1% weight) and add to your positions as you build conviction either in the business or in the valuation. Avoid concentrating in any stock however appealing, based on misguided FOMO.  

What we do: We do not give a readymade portfolio of stocks or suggest weights because we think there cannot be a one size fits all approach. A stock portfolio needs customization to suit your style, risk and return preferences. We provide you with a list of investment-worthy stocks. Blend these ideas into your portfolio, using some of the simple principles we have listed in this article. We highlight the risk level for each stock (based on its volatility in relation to the index), to help you decide on weights.

# 5 Having a cash component

The timing of your entry is an important determinant of how smooth your journey is and the total wealth it creates for your portfolio. Investors who were intrepid enough to buy during the March 2020 lows would have pocketed hefty returns even if their stock picks were so-so. Those who jumped in at January 2008 or February 2000 market highs, would have had sub-par returns for a decade even from best ‘quality’ picks of those eras.

This argues for having a tactical cash component to your portfolio, based on overall market and individual stock valuations. Retaining a cash component to your portfolio at high valuations can leave you with sufficient dry powder to deploy when prices correct. A cash component would also be useful to accumulate your watchlist stocks when prices or business conditions turn right.

It would be best to base your portfolio cash level on preset rules (can be based on quantitative or qualitative indicators) rather than leaving it to open to emotional decisions.

What we will do: We plan to come up with our recommendation on how much cash allocation is advisable in different market conditions. You can use it as a pointer to set aside some liquidity.

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12 thoughts on “How to build a stock portfolio”

  1. Hello, your articles are so informative and rich. Please keep them coming.

    When do you plan to launch the following:
    “What we will do: We plan to come up with our recommendation on how much cash allocation is advisable in different market conditions. You can use it as a pointer to set aside some liquidity.” Really look forward to the cash% suggestions.

  2. 18 – 30 stocks was the portfolio size advised. If we have a March 2020 scenario and have more stocks which we desired at appropriate valuations, can we venture to go even up to 50 stocks or beyond. Is “difficult to monitor” and “difficult to follow the many sectors” the reason to avoid such wide portfolio?

    Regarding diversification:
    If we consider a broad area such as for eg. CHEMICALS, there will be many branches such as fertilizers, paints, speciality chemicals, pigments etc, CAPITAL GOODS – construction machinery, industrial machinery, heavy electrical equipment, electrical components, construction/engineering works, building products etc. We may find value stocks as well as growth stocks in each of these areas. Can there be a recommendation regarding diversification among the broad categories/sectors and then further diversification among the sub specialities.

  3. Amazing thoughts. Going through your well spelt out strategies was like an excellent refreshing course. I must candidly admit that Prime Investor is the best thing to have happened in 2020 to hone our wealth creation skills. I am almost fully invested to the extent of 98-99%. Looking forward to your wisdom on cash allocation strategy. Further, your thesis on portfolio sizing is excellent. If I may wish more, your thoughts on sectoral approach like the no of sectors in the DIY investors portfolio would be even more helpful.

    Query : Financials in my considered opinion must include lenders in Banking space and NBFCs, Insurance & AMCs and even Brokerages & Credit Card Co as well. In this backdrop, is your suggested allocation of 20-25% to financials restricted only to lenders?



  4. Mam, have been a big fan of your articles since many years during your stint at Value Research.
    Very informative and educative article for newbie investors beginning their direct stock investing journey. Hope to read many more such articles from your side.

  5. Sivasubramanian Viswanathan

    Hello Aarti, Well written and informative for sure.

    Few questions from my side:-

    1. I have emergency fund for say 10 months & still I have surplus cash of say 10 Lakhs, should I park in short fund or long term equity, as I do not need for 2 years at least. Some tips. (not interested in FD)
    2. Coming March 2021, one of my PPF getting matured for about 16 Lakhs, what is your views on investing this into a 2-3 years horizon as I do not intend to buy any items or EMI’s. (other PPF account am planning to extend to 5 more years). Interested in top-up stocks rather MF.

    Thanks in advance

    1. We can’t give customised advise as we are not RIAs but best to use short term or ultra short debt funds with high quality portfolios for 2-3 years. For equity you need a minimum 5 year horizon specially now

  6. Is there any – ETF Debt to park money during bull run and then deploy it back during corrections ?

    1. There is liquid BEES a money market ETF which trades at constant price and pays a daily dividend.Not very tax efficient. Open end liquid funds or overnight funds may be better.

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