Spilling the Beans: How AI constructs a portfolio

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We continue to share our approach and process with “Ace Readers” which can benefit them in the long run. Many research houses will feel shy in sharing their methodology but we do not. It is imperative that as “Ace Reader” of AI Post, you gain knowledge and wisdom over a period of time. The objective is to share pieces of information to make you a better investor who is prepared for long term wealth creation. Coming back to today’s post, this is the second and final article of the series which talks about nitty gritties of constructing a good portfolio. In the previous article, we shared our checklist for picking a multibagger stock. (click here to read)

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Let’s first go into the details of “WHAT” is the expectations from a good portfolio and then discuss “HOW” to achieve the same.

What is a good portfolio?

  • It should be able to generate superior risk adjusted returns. Here risk adjusted returns is of significance. A high risk portfolio can achieve higher returns by taking more risks (like positional bets, high flying stocks etc) and vice versa for a low risk portfolio. Over longer periods, returns will start reverting to the mean so neither a high risk portfolio nor a low risk portfolio will yield best results over long term. It makes sense to have a blended approach which takes manageable and measurable amount of risks to generate superior returns over long term.
  • It should be a consistent performer with respect to the benchmark. A good portfolio should be able to post returns which are consistent and can be plotted as a linear graph. It should not be zig-zag or V-shaped. People will loose faith in highly volatile portfolios and make exit mid-way.
  • It should align to the stated guidelines. This means if a portfolio is small cap oriented then it should not include large caps. Investor puts his faith by believing in certain portfolio construction guidelines which matches with his investment preference. So portfolio construction should adhere to the investment guidelines all the times .
  • It should have a low churn rate. This means portfolio should not shuffle too many stocks in a year. High churn rate (shuffle rate) means lack of belief in the stocks being recommended. Also, multibagger returns start to accumulate typically after 3 years period. Higher churn rate will never let compounding to do its magic.
  • Portfolio should be cost effective. The cost consists of administration as well as transaction costs. Most PMS (Portfolio Management Service) providers will charge on a fixed price plus a percentage of the gains made in the year. They do not share your losses. This model is flawed and tilted towards the interest of PMS service providers. In reality, the cost of running a portfolio (including research and operations cost) should remain the same irrespective of the fact if a client is investing in crores or lakhs. So technically, charges should be fixed to cover the operations cost plus a margin. Anything more than that is just exploitation of clients in the name of profit sharing. You will see many popular figures on TV channels promoting certain point of view or stocks. You should never blindly follow them but take their suggestion as just another pointer which needs further analysis.

How to build a good portfolio?

  • Focused Approach: You can not have a portfolio running into hundreds of stocks as it will never give superior returns. While mutual funds do have 80 to 120 stocks in their portfolio, it is done to park huge sums of money. They have operational challenges and mandates from SEBI which forces them to have big portfolio. Various studies have proven that ideal portfolio should have somewhere 12-20 stocks in them. Adding 21st stock will not move the needle but will surely dampen overall returns. Read our previous article on the same topic.
  • Diversification: This is a widely known fact that portfolio should be diversified across different sectors. Never put all eggs in the same basket. Diversification is a broad topic and can have various dimensions. For most investors, a portfolio having stocks from different sectors from Indian stock market should be good recipe for wealth creation. However for multinational companies and international investors, diversification extends into different geographies and asset classes.
  • Market Cap Blend: Large cap stocks tend to be more stable than small caps but latter provides more returns. A portfolio can be constructed which can maximize returns by loading appropriate amount of small and mid cap stocks, while presence of large caps can reduce return volatility. This depends on individual investor preference. We at AI, keep this ratio as 20% Large Cap, 40% Mid Cap, 40% Small Cap. We believe this is a very optimal ratio which can deliver stable yet exciting returns over long term. For someone with medium term outlook, allocation towards large caps should be more.
  • Industry Cycle Blend: In stock market, different industries have different cycles from boom to bust. Every year few industries are on the rise while few others are fading away. To generate consistent returns, a portfolio should keep on infusing new stocks from the bottom of cycles. If it keeps only booming industry stocks, then returns will oscillate wildly. Remember +20% & -20% are worse than +0% returns. For example, if a stock goes from ₹100 to ₹120 (+20%) & then comes back to ₹96 (-20%), an investor goes down below his initial investment. On the extreme end, portfolio can not have only contra bets as this will generate returns only once in every five years or so.
  • Longer Holding Periods: Stocks should be held to squeeze out maximum return potential from them. Once you have identified a good stock then it should be viewed as an opportunity which can be converted into multibagger returns. Many portfolio lacks this vision as they sell stocks at merely 100% returns. While real compounding starts post 100%. To draw a parallel, you must have noticed in cricket that Rohit Sharma converts his 50s into 100s or even 200s. He is a multibagger scorer 🙂

At AI, our portfolio service MultiCAP Multibagger is broadly run on the principles described in this article. We have an objective to generate 16 times returns in next 10 years and so far, we have been exceeding this objective. To join our service, please contact on our whatsapp chatline +91 9958092336. For various subscription plans,  please click here.

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