We all understand that creating a portfolio is the key to creating long term wealth in a systematic and organized way. A focus on debt gives us the stability and regular income that is the cornerstone of any portfolio. But the real intent of any portfolio is long term wealth creation. That can only happen with a well selected and well crafted portfolio of equities.
However, creating an equity portfolio is easier said than done. We need to understand that creating a portfolio is not just about buying good stocks but also about buying a good combination of stocks. When you create a portfolio of stocks it is not just the performance of these individual stocks that matter but also the combination of these stocks that tend to matter. There are 6 basic rules that one can follow to create an effective and meaningful portfolio, which can be understood through these 6 basic mistakes that people normally commit when creating an equity portfolio.
Loving or hating stocks a little too much
We have all heard of the popular phrase of “Falling in love with the stocks you own”. That is a common problem in portfolio creation. Having identified a stock most investors refuse to accept that the fortunes of the stock or the sector have structurally turned. SBI was always a great company and most Indian investors have had an attachment for that stock. But over the last 7 years, the stock has consistently underperformed due to structural NPA related issues. No point in holding on to the stock till these structural problems are resolved. The counter argument also holds true. Most investors have been wary of stocks after they have booked losses in the stock. That is another mistake in portfolio creation wherein you are allowing your emotions to get the better of you. Each stock and investment proposition must be looked at purely and objectively on merit.
Not matching your risk with your time horizon
This is a mistake most of us do not realize. Let us take a macro example. Typically, equities tend to outperform other asset classes over the longer term but in the shorter term there could be possibilities of underperformance due to volatility in the stock. Logically, your long term money should go into equities and your short term money should go into debt and other fixed income instruments. When you are planning for your retirement after 25 years, it is a waste of opportunity to create a portfolio that is tilted in favour of debt. Similarly, when you are looking at a commitment after 2 years, you should ideally match your time horizon by predominantly staying in debt.
Trying to time the market and overtrading
When you are creating a portfolio you need to use charts and technicals to get a good price. But it is not your job to try and time the market. Remember, buying at the bottom and selling at the top exists only on paper and even the best of investors have not managed to consistently do that. More importantly, there will be occasions when you will have to book losses and exit a position. That is part of the game. Don’t ever try to recoup these losses by overtrading in the market. You are likely to hit your portfolio both ways!
Adopting a rear-view approach to investing
Let us understand this analogy a little better. When you drive a car, your focus always has to be on the front not on your rear view mirror. You cannot move forward if you are stuck in the past. So, how is it relevant to your portfolio creation? There are 2 ways it actually matters! Firstly, there will be a history of profits and losses along the way. There will also be right decisions and wrong decisions. When you are taking a portfolio decision today, do not let your past conditioning impact your judgement. Secondly, champions and outperformers of the past could be laggards of the future. We have seen many such cases in Indian large caps too. Most of the champions of today were not even listed 25 years ago. That is why a rear-view approach will not help you!
Risk of not diversifying your risk sufficiently
Warren Buffett may have waxed eloquent on the merits of concentrating your portfolio but while creating your portfolio you need to focus on mitigating your risk. You need to spread your risk across sectors, across themes and even across asset classes. Putting all your eggs in one basket has never been a good idea. It, perhaps, never will be!
Failing to understand correlations in portfolios
This is one of the lesser understood aspects of creating your portfolio and is linked to the previous point on diversification. When you diversify, how do you choose how to diversify? The answer is that you need to choose assets that have low correlation or negative correlation. For example, an oil extractor and an oil refiner will have a negative or low correlation. Similarly, an airline company will trade in a converse pattern to an oil extraction company. You actually reduce your risk by combining stocks with low or negative correlations. Even if you buy many stocks with similar risk profile, it may not help you diversify your risk beyond a point.
Portfolio creation is not just a one-time activity. By taking care of the smaller points in portfolio creation, a lot of the larger issues can take care of itself.
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