Portfolio Construction – An Introduction

The long term goal of building wealth in markets starts from being able to get right a portfolio of stocks that suit ones risk tolerance. Take too much of risk and you may jump ship well before the goal is reached, take too little and your goals may remain unfulfilled.

So, what is risk?

While risk is often defined as the volatility of the investment, Warren Buffett sees Risk as Permanent loss of Capital which seems to make much more sense when taken in the context that no investment (other than Fixed Deposits) will yield a return  without some amount of volatility.

Hence when a portfolio is being build, one has to ensure that the risk of permanent loss of capital is kept low. But then we come to the axiom which seems to say that Risk and Reward go hand in hand. Higher the risk, Higher the return, or so goes the saying.

But as Howard Marks says, while its true that market appears to provide higher rewards for assets that seemingly have higher risks, its worth noting the word “appear.” We’re talking about investors’ opinions regarding future return, not facts. Risky investments are – by definition – far from certain to deliver on their promise of high returns.”

By creating a portfolio of stocks, the idea is to minimize those risks by spreading them across. But the question that comes up next is that while its true that its better to have a basket of securities, how many should one have. Should one have a few stocks which one beliefs will deliver strong returns or spread it thin across many stocks to ensure that one or two bad apples do not negatively impact the net portfolio.

Below here, I have reproduced in graphical form the damage a portfolio can see from a stock that has fallen 25% from the entry price (Equal investment is assumed in all the stocks)

The chart above shows the damage to a portfolio in case a single stock among the portfolio constituents goes down by 25%. The impact is highest if the number of stocks in a portfolio is just 5 and the lowest in case the portfolio consists of 50 stocks.

On the other hand, we get a similar number if a stock moves up by 25%. For a portfolio with 5 stocks, the net value of the entire portfolio moves up by 5%. On the other hand, in the portfolio of 50 stocks, this barely makes a dent as the portfolio climbs a partly 0.50%.

We believe that a good portfolio can be of 20 – 25 stocks which in essence will mean that the investment in each stock is limited to 4 – 5 percent. But the choice comes down to both the risk taking capacity as well as the goals one defines.

There is a large amount of reading material that is available on the internet that goes into every little facet concerning portfolio management and construction and it can help one a lot.

In our future posts, we shall attempt to build portfolios using various proven methodologies. But for now, lets wrap it up with a nice little presentation from Vanguard (Link)