Risk Management and Diversification in Stock Markets

My opinion on risk management and diversification in stock markets have kept on changing with time. But, the recent thought process has stayed with me for the past couple of years, and I think the time has come to write it down. Here is what I think about diversification and risk management.

a. A diversified portfolio in itself does not ensure that you don't suffer large losses. I learnt this lesson in 2008, when my portfolio of more than 20 stocks went down by 67% in a year. For that matter, go and look at the history of most of the mutual funds for 2008. All of them made similar losses in NAV for that year, even those which had 100s of stocks in them.

b. The natural question that comes to mind is how to protect one's portfolio. In my opinion, there is no option other than having a stop loss to prevent the losses. You must define a threshold level, beyond which you will eject yourself out of the market, however painful that might be and however attractive the scrip may appear. Think about it from the reverse perspective: if the stock was so attractive, it would not have fallen by that much percentage in the first place.

c. Point b above clearly demolishes "buy and hold" strategy, which should be applied only by people who can't exit certain stocks at a time of panic, as their holdings in the scrip are too large to be disposed of. It is very good for Warren Buffet to preach "Buy and Hold", as his holdings in most of the companies is so high that he can't exit in a panic scenario. Individual investors should not get fooled into following something, which is a limitation for large investors.

d. Point c limits the amount and the scrips in which individual investors can invest. The natural conclusion is not to invest in companies with low volumes, unless your own investment is very low. E.g., if a company trades on an average 100 shares daily and its price is 50 Rs, and you have invested five lakhs in it, you may have to wait for 100 days ( around 5 months) to exit this share, if only your shares were executed. That means with only five lakh Rs., you become Warren Buffet of the stock. You can sink and raise prices of this stock at your whim. As a rule of thumb, I don't buy more shares than daily traded average volume of the last three months in a company. If you have to pass a company because its daily traded volume is so meaningless that it won't make an impact to your portfolio, please do so.

e. Following b, c and d above provides the best chances for an individual investor to protect his portfolio. Besides this, one should keep an eye on Nifty/BSE PE levels and when they trade in historically top quadrants of PE (23-28), one should move a substantial percentage in cash, debt and other instruments, and wait patiently for markets to self correct and give an opportunity. Similarly, if the Sensex is in the bottom quadrant of PE (10-14), one should become aggressive and even may use leverage. (Personally, I have not gotten a chance to implement this point, but whenever I get an opportunity next time, I will definitely follow this).

f. Once you have your risk management in place by implementing above points, one should only look for the best stocks, which have a very high probability of giving high returns. In my opinion, it's difficult to find even ten such stocks at any point of time in the market. The more comfortable number is around five.

g. One final point, the companies that you invest in, themselves should not be cyclical, leveraged, negative operating cash flow companies, high promoter pledged or struggling companies that are waiting for turnaround as that might not happen soon enough. If you do that, it is more likely that even with a reasonable stop loss, you will not have to churn your portfolio often enough. One more caveat is that you have to give wider stop losses for the companies that have risen sharply in recent time, so the stop loss percentage can't be a hard and fast rule and it might have to change with time. But, not having one is suicidal.

And finally, risk management and diversification are clearly two different things, which people generally mix, while there is no anecdotal evidence to suggest that a diversified portfolio is more protected.