A successful self trader – Rule # 42
THIS RULE IS APPLICABLE WHETHER YOU ARE A TRADER OR AN INVESTOR. THE LARGER THE STOCK UNIVERSE, THE LESS TIME AND ENERGY YOU ARE ABLE TO DEVOTE TO EACH OF YOUR POSITIONS. ALSO, IF YOU ARE LOOKING AT DIVERSIFICATION OF YOUR RISK, IT HARDLY WORKS BEYOND A POINT. BEYOND THE FIRST 8-10 STOCKS, YOU ONLY END UP SUBSTITUTING RISK, NOT MITIGATING IT. YOU ALSO MISS OUT ON SCORES OF OPPORTUNITIES THAT GO DOWN THE DRAIN. WATCH OUT!
SMALL IS DEFINITELY BEAUTIFUL IN STOCK MARKETS
Back in 1994, when Morgan Stanley Mutual Fund had entered the Indian share market, they committed a cardinal blunder. Having raised a huge sum in their NFO, they just went berserk buying almost any stock that was available. Their original portfolio had hundreds of stocks, which the fund had neither the time nor the capacity to track on a close basis. Eventually, they took years to trim down.
When a global institution of that standing falls prey to the thin-spread syndrome, you do not expect retail investors to do any better. But some of the reasons are too hilarious. An investor, I used to speak to, held close to 140 stocks in his portfolio. His argument was that he had bought these stocks at dirt cheap rates and hence had no incentive to sell them. That is surely something.
Warren Buffet and Peter Lynch had best illustrated the need to keep a manageable universe of stocks. Lynch went to the extent of saying that one needs to keep their portfolio simple and stupid. The truth is that if you cannot buy 3 multi-baggers, then it is highly unlikely that you will identify 30 multi-baggers. In the process, you make your universe complex and hard to track. Avoid it.
THREE QUESTIONS TO ASK BEFORE EXPANDING YOUR UNIVERSE
- DOES THE STOCK ADD VALUE TO MY PORTFOLIO?
If you are already holding Bank of Baroda, why add PNB, BOI and Canara Bank too? They are all driven by the same set of factors. If you want to add your position, rather focus on a BOB or PNB alone. Why add birds of the same feather that add not incremental value?
- DOES THE STOCK REDUCE RISK OF MY PORTFOLIO?
Extend the above example. If you add more banks of the same kind, they will all be driven by the same set of factors. So where is the diversification? You are not mitigating risk, only substituting it. Risk remains the same. Think about it.
- CAN I KEEP A TAB OF ALL THE RELEVANT VARIABLES?
This is a million dollar question. Every company is impacted by a plethora of factors that are at times independent and at times inter-connected. You surely cannot track that for a portfolio of 140 stocks. Keep it simple and stupid.
“There seems to be a perverse human characteristic that likes to make easy things absolutely complicated” – Warren Buffett
6 WAYS TO KEEP YOUR STOCK UNIVERSE SMALL
- If you are a trader, keep your total outstanding positions to a bare minimum. If you have twenty short and twenty long positions with over 30 neutral positions, then you yourself do not know whether you stand to win or lose when the market moves. Your net position should define your philosophy.
- Ask yourself this question. Am I buying a new breed of assets or am I buying more assets of the same kind? If your answer is the latter, just avoid it. You want to use your limited capital to add new ideas that can add value. You surely do not want to focus on buying more of the same thing.
- Do not forget the risk angle. If the stock you are adding is going to be affected by the same set of macros, it is not going to reduce your risk. Focus on stocks that are negatively correlated. Oil gets hit by weak dollar and IT companies benefit. An Infosys can counter the risk of ONGC, not Oil India.
- Warren Buffet gives a simple rule; “List down all the stocks that you own and also list down all the factors that impact these stocks”. Once the chart is ready, describe your entire portfolio in one single sentence. If you cannot do that, then you just own too many stocks and have no control over the portfolio.
- Keep an SNAV list ready. These are the Stocks Not Adding Value. When the contribution of a stock in your portfolio has not been great in the last 3 quarters, transfer it to a subsidiary portfolio. The core portfolio must not be tampered with, but the subsidiary portfolio can. That is the key.
- Keep an industry wise concentration always ready with you. In happy times we tend to binge on happening stocks. That is ok. But a sectoral chart will tell if you are getting concentrating in one or two sectors. Your priority should be to reduce and shift additions to other sectors. That will surely work.
DON’T JUST BECOME A SUCKER FOR DIVERSIFICATION
It is normal for advisors to tell you to spread yourself thin to reduce your risk. Believe me, it just does not work. It not only fails to reduce the risk of your portfolio, but adds unknown variables to your portfolio. While it is hard to put a number, any core portfolio should be restricted to about 12-15 stocks. And if you are trader, anything above 6-8 open positions is not a great idea. Smaller is always better in this business.
When you buy a stock, you don’t just track the price of the stock. They are a plethora of other variables that you need to look at. Are the stocks liquid and can I exit without price impact? Are the margins and profits showing growth? Is the company in a business that can add some unique value to shareholders? Is the stock in tune with industry wide P/E, P/BV and margins? Now how do you practically track all these variables for a universe of 50 stocks? It is practically impossible.
TAKEAWAYS FROM THE “RESTRICTED UNIVERSE” DEBATE
Peter Lynch once said that the number of stocks you own and its characteristics, you must able to illustrate with a piece of crayon. What he meant was that any portfolio that will be impacted by a cross matrix of variables is not a great idea. When you expand your universe of stocks beyond a level, you neither derive the benefits of reduced risk nor are you able to effectively keep a tab on the performance of all your holdings. A restricted and well thought out universe, always makes more sense.
THIS IS A UNIVERSAL RULE AND APPLIES TO ALL FORMS OF ASSET CLASSES AND MARKET PARTICIPATIONS, WHETHER YOU ARE TRADER, A LONG TERM INVESTOR OR EVEN A MUTUAL FUND INVESTOR. THE PERILS OF DIVERSIFICATIONS ARE APPARENT EVEN IN COMPANIES. COMPANIES THAT TRIED TO MAKE EVERYTHING FROM PINS TO AEROPLANES HAVE PAID A HUGE PRICE IN TERMS OF PROFITABILITY AND VALUATION. THE SAME LOGIC APPLIES TO YOUR STOCK PORTFOLIO TOO. IN TRYING TO BE SOMETHING FOR EVERYBODY, YOU END UP BEING NOTHING FOR ANYBODY.
You can ask us your stock related questions with #AskReligareOnMarkets via our Twitter channel @religareonline