Why we need a philosophy to investing
When you come to a road crossing, how do you decide which way to take? Do you follow the road signs, look at the map, ask someone for directions, or just go right ahead and take a random shot?
If you choose to follow the first option, then you do have a certain philosophy at work. As the Cheshire cat put it so eloquently in Alice in Wonderland: if you don't know where you're going, it doesn't much matter which road you take to get there. Obviously this means that you need to, first and foremost, develop an idea of where you wish to go with your portfolio. No, just "we want to make money" is not enough - a good start maybe, but not enough to qualify as a philosophy!
What is an investment philosophy?
"An investment philosophy is a set of guidelines by which investment decisions get made. These guidelines help to achieve the well-defined goals of the investor. These guidelines are usually informed by academic findings, actual experience and/or desired investment goals. The important point here is that the investment philosophy represents a set of guidelines and not fixed rules."
My Rule No. 1: Think Portfolio
When we invest in the equity market, we never think of investing in one single stock. We always look at buying more than one. Many of us buy more than 30. In the course of our practice, we have come across people who own 500 stocks in their portfolio!
My Rule No. 2: The objective is diversification of risk
You might want to ask us at this point if a portfolio consisting of only 10 (for the sake of argument) steel companies constitutes a good portfolio? No. The portfolio approach calls for diversification. And you do not achieve that when you own a portfolio of just 10 steel companies. The factors that affect the steel business will take their toll on each of the steel companies. Even the market risk does not get spread out. Hence, this portfolio is as risky as one with just one steel company. It fails because there is no diversification across various businesses. An important point to note is that while we advocate diversification - diversification is the means to an end (returns), not an end in itself.
My Rule No. 3: Don't spread your net (portfolio) too wide
We believe that by casting our net wide across many stocks, at least a few of them will turn out winners. We spread it to decrease risks. However, most investors forget that there is a trade-off between risk and return. As the number of stocks keeps increasing, not only does the portfolio become unmanageable, it begins to reduce your total return. Using a medical parallel, think of it as too many pills resulting in an undesirable side effect!
As a rule, WE advocate that the number of stocks in a portfolio never be more than 15 or, at the maximum, 20. Beyond this, it becomes difficult to track so many companies (and they start creating holes in the portfolio). Also, do the arithmetic: if a stock accounts for just 1% of your portfolio and it doubles, your portfolio return goes up by just 1%. Hardly anything to get excited about.
My Rule No. 4: Determine your risk profile before creating your portfolio
You cannot have low risk and high returns. We hate to disappoint you, but that is the truth. There are no magic wands. You cannot "have your cake and eat it too." A portfolio is always a trade-off between risk and return. Having a portfolio is all about balancing between these two opposite forces. Hence, it is important that you understand your risk profile before creating a portfolio.
Portfolio creation is all about optimising returns, given a risk profile and an investment horizon.
Some final tips
Well, that's about it for the rules and philosophy of investment. But before we finish, We would like round off this session with some more words of advice...
Recognise your risk profile: Your risk profile is a function of your age, ability to withstand losses, investment horizon (time), existing cash flows (income), past experience and expectations from the market. Risk profiles are unique to every individual and they can only be classified into broad categories to simplify issues.
Think "clusters" the way we at Sharekhan do: We have created clusters that stand for certain risk-return profiles. Our Evergreen cluster, for instance, has the lowest risk. The risk increases starting with our Apple Green cluster to our Emerging Star cluster. Ugly Duckling and Cannonball are "quick churn" clusters, again standing for different degrees of risk.
Conclusion
Seek to build a diversified portfolio, which will double its value every three years. There are going to be bear and bull cycles. It's always going to be difficult, if not impossible, to keep up with those cycles in a bid to make the most of the volatile markets. An investor needs to live out these cycles and survive, for there is no guarantee how long a bear market can last. The idea is for you to last... much longer than it! And only a disciplined philosophical approach to investment will show you way to that goal.
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