February 10, 2012

Raising portfolio quality

A bear market is a time for lots of activity for me. A 25%+ drop in 2011, with a near collapse towards the end of the year, threw up a lot of opportunities. During such times, the problem for me is that my portfolio soon starts resembling a zoo – it has a stock of each variety.
How do I end up in such a place?
I personally ignore short term forecasts and start buying a company (usually too soon) if the valuations are attractive and the long term prospects are good. The problem with this approach is that there is no grand strategy behind it. As a result I often end up with too many stocks in my portfolio
I have gone through such a phase several times in the past (in 2005, 2008 etc) and have had to prune my portfolio after that. This time around, I made a decision to limit myself to around 22-25 stocks and any further addition would require me to sell something – keeping the total number the same.
Now, one may argue that even 20-22 stocks are too many and one should have a more focused portfolio. Let me assure you that once I gain more experience and hopefully some wisdom, I will scale back the number to 15 or less. Till then this level of diversification is an insurance against my ignorance or stupidity.
So why limit yourself?
A different way of looking at this issue is to question the need to limit oneself to any fixed number of stocks. If you can find enough good and cheap stocks, why not load up on all of them?
I have followed this approach to a small extent in the past and have realized that this results in mental laziness. Once I buy a stock, the endowment effect kicks in and then I am reluctant to change my opinion on the stock even if the company is performing below average.
In all such cases, I have finally come to senses and have sold the stock usually at a small loss. The real loss however is the opportunity cost of deploying this capital in some other high quality idea.
What is the difficulty in exiting?
It would seem very easy to exit such stocks on a purely rational basis.  You look at the original thesis of the purchase (for example - the company will grow at X %) and compare it with what has happened since your purchase. If the company is performing below expectations and will continue to do so, then you sell the stock and move the capital to a better idea.
If only life was this easy ……
The emotional part
I find the emotional part of selling a stock, which has not done well to be a painful exercise. For starters, one has to admit that one has been wrong or unlucky (usually wrong) and in hindsight should not have bought the stock.
The next problem is to find another idea to replace the one being sold, which in turn will hopefully not be dud.
The worst of both worlds is to see the old stock soar in value after the sale (yes, I have had this one too – VST industries) while the new pick stagnates.
Selling to raise the quality
There are times when if you are fully invested, the only way to invest in a new idea is to sell an existing one. I have created an artificial constraint by limiting myself to 20-25 stocks. This constraint has now forced me to rank my stocks in an order and to look for the weakest ideas in the portfolio.  How do you do the ranking? Well that’s another post, and stock price is not the only criteria.
The weakest idea now gets compared to the new idea and if the new idea is much better, then it replaces the weaker one. You can call it the survival of the fittest – each stock has to earn its position and cannot just stay put in the portfolio. There are no holy cows!!
So which of my ideas are facing the axe? Some minor ones have already been axed. I have been reviewing the Q3 results and have a few more on the chopping block now (this one is a good candidate)
Selling the mediocre ideas to buy a more attractive stock is always painful for me, but over time I have found that my overall performance has benefitted by swallowing my pride and biting the bullet.

Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please read disclaimer at the bottom of blog.


Abhi said...

Would you not buy more of the same ( once you already hold) when market goes down? Maybe you add 2-3 more of ideas you really like, but would you not think of loading up on ideas you already own when market goes down like the in 2008 or in recent times?

Lalit said...

Thanks Rohit for the post. I am trying to follow a similar strategy. Many times the best stock to buy is the one that you already hold. Any new idea has to be at the cost of the existing one. I am trying to limit to around 20-25.

Anonymous said...

Great post Rohit.

Looking forwared to the ranking post. Its going to be interesting to say the list. How much weightage to give to a factor will be the most difficult/imp part I guess. I know its subjective but, sometimes I feel the more mechanical you try to make the investing process, the less value it adds.

Dhwanil Desai said...

Hi Rohit,

You have touched upon a very interesting topic as almost every investor faces this dilema over one's investment tenure.

For me, I like the approach that Peter Lynch has suggested whereby you have 80% of your investment portfolio in 15-20 stocks (your best bets) while create smaller positions in other interesting ideas. This approach will help one keep track of interesting opportunities without making large commitemetnts. On the other hand it gives ample time to analyze these ideas from all aspects and successfully fight the "itch" to invest once the investment starts to look promising, prima facie.

Rohit Chauhan said...

Hi abhi
you are right ..i would load up on some of the same idea. but a lot of time once i have a full position, i will not exceed that in interest of controlling risk. there is always an upper limit on the amount i will bet on a single stock


Rohit Chauhan said...

Hi lalit
same here ..except i try to also keep a limit on the position size. try not to exceed that ..it is always easy to get carried away by what you own


Rohit Chauhan said...

Hi dhwanil
I also track quite a few stocks ..but i dont actually own them ..just keep them on a spreadsheet to see what is happening with them

in the end comes down to the same point


Anonymous said...

I have a question. You say you have a limit of exposure to any stock is it based on % of portfolio or a amount limit.

I have a 18 stock portfolio but i am not expert like people here i have mostly bought on instinct and by reading research articles like you people. My question is i am a salaried guy who like to put in a fixed amount to my equity investment every month. how should i manage the investment then? keep the amount as cash until i see a opportunity or invest them in the stock i have made position already?

Rohit Chauhan said...

Hi anon
I am in the boat as you ...salaried guy and not some hot shot fund manager.

my personal approach is to figure how much money i can allocate to equity. lets say 10 lacs...then typical position will be 5% or 50000 for me. if i like something a lot then max it will be 1lacs

begining of each year i roughly know how much i will save and based on that i know how much cash i will have. as the money comes in, i let it idle till a good idea comes up and an exisiting idea becomes cheaper and then i put my funds to use.


Tips_Commodity said...

Hi Rohit ...
Since I am new to this field of investment, I really liked the way you have described which stocks are good, and give good returns. Looking forward to more of your posts !!!