Published on March 5, 2021
Ahmedabad: What’s a good number of stocks in the portfolio to assure investors a better cover against the proverbial ‘market risks’? A study carried out by an IIM Ahmedabad (IIM-A) professor and a Singapore-based investment firm director assessed more than 50 Nifty stocks over six years and deduced a safe number would be between 40 and 50.
Prof Sobhesh Kumar Agarwalla from IIM-A and Rajan Raju, director of Invespar Pte Ltd recently put up their working paper titled ‘Equity portfolio diversification: How many stocks are enough? Evidence from India’ on the institute’s website.
“We show that a 15-20 stock portfolio, the traditional market rule-of-thumb for a diversified portfolio, is likely inadequate to minimize unsystematic risk. We show that an investor could target to reduce diversifiable risk by 90% with 90% confidence with a portfolio of 40-50 stocks,” stated the duo in the paper.
The findings are important in the light of the fact that the number of demat accounts in India recorded manifold rise during and after the lockdown period as more people turned to investing in stock markets eyeing better returns.
The duo analyzed performance of a total of 760 stocks between December 2014 and December 2020 – given some joiners and leavers from the index. They simulated about 50,000 portfolios with different permutations and combinations using two durations – one year and three years.
“It would take around 40-50 stocks in an equal-weighted portfolio to give the same investor 90% confidence to diversify away 90% of diversifiable risk. As the confidence level required or the amount of diversifiable risk to be reduced increases, the investor would need to hold a larger number of stocks in their portfolio (compared to 15-20),” said the paper.
Market experts said that the idea of a wider portfolios in sync with the ground reality. “Over the past decade, industrial segments have expanded, and specializations increased across sectors. For example, the IT sector – which was previously limited to software, BPO and KPO – now has segments such as cloud, data centers, gaming, etc. Thus, one may not be able to cover the market with 20 stocks,” said Vaibhav Shah, managing director of Monarch Networth Capital, an Ahmedabad-based financial services company. “Wider portfolio with 40-50 stocks can provide a cushion against the market volatility.”
‘Investor’s trust in riskiness of portfolio imp’
Ahmedabad: How does an investor choose stocks and ensure diversification? A working paper by Prof Sobhesh Kumar Agarwalla from IIM Ahmedabad (IIM-A) and Rajan Raju, director of Singapore-based Invespar Pte Ltd titled ‘Equity portfolio diversification: How many stocks are enough? Evidence from India’ points at an investor’s confidence level at ‘the given riskiness of the portfolio compared to the market portfolio’ to arrive at the holdings required.
“Moreover, investors also check the historical variance of portfolio returns vis-à-vis the chosen benchmark returns to determine diversifiable risk carried in the portfolio,” mentioned the paper.
The researchers mention that simulation for the study and real-life scenario are different as investors select stocks based on specific reasons. But a well-balanced approach can help them target risk reduction and increase confidence level.
“I do not agree with the idea of having a portfolio of 40-50 stocks. If an individual investor wants to have so many stocks in his portfolio, he or she should invest in mutual funds,” said Nilesh Kotak, a city-based stock analyst. “Charlie Munger, vice-chairman of Warren Buffet’s Berkshire Hathaway, had famously claimed that his portfolio consists of only 3 stocks. Thus, the key is to have a well-balanced portfolio in terms of fund allocation,” he added.
Bankim Merchant, a business associate with Motilal Oswal, said that the portfolio size and composition depend on the investor and advisor’s planning.
“Along with stocks, the investors now have options such as mutual funds and exchange-traded funds (ETF) to reduce the risk and diversify their investment. But we often see that the investor doesn’t want to miss on the ongoing trend and wants to acquire or sell specific stocks rather than holding on to it,” he said, adding that commitment level – period for which the stock is kept like 1 year to 10 years – also plays a major role. “Certain firms have also created products which not only invest in stock, but also equity debt, international stock and gold/commodity to diversify.”
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