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A Sector / Industry is a collection of companies that do same or similar businesses.
Though technically, Sector and Industry different, for the sake of understanding this lesson, we will use them interchangeably.
When investing, diversification of our investment across different sectors or industries help us reduce risk.
Lets read on to find out more on this.
Before we start on the topic of the day, let us do a small revision from our previous clases.
- Rule #17: Invest only in shares where FIIs have invested in
- Rule #18: Invest only in shares where DIIs (in particular Mutual Funds) have invested in
FII and DII are big market participants. They invest a lot of money, do thorough research and often hold for a long term.
They follow strict quality practises. So when they buy a company (or sell), it does mean a lot!
Hence we take their activities into our rules.
Then we created a rule:
The rationale behind this is that when a stock is at 52-week high or all time high, the further growth from CMP levels would be limited unless the company does something superb.
God forbit, if wee invest at such high levels and if the stock begins to fall, it turns out to be real disaster for us.
- Rule #20: Do a business fundamental analysis to understand the positioning and identify opportunities of the company
Hope you have understood them.
- 1 Introduction to Diversification
- 2 What is a Core and Non-core Portfolio?
- 3 What exactly is a Sector and Industry?
- 4 Some ever green sectors
- 5 Why Diversify?
- 6 How many companies can our demat hold?
- 7 Contra Stocks
- 8 How many companies to invest in?
- 9 Assignment - Core Portfolio Building
- 10 Assignment: Sectors of our invested companies
- 11 Assignment: Model Portfolios
- 12 Question: Three banking stocks
- 13 International Classification of Industry Sectors (for Investing)
- 14 GICS Classification
- 15 Assignment on GICS Classification
- 16 Assignment: Long Term Portfolio Planning
- 17 Over-diversification
- 18 Additional Reading Reading
- 19 Related Lessons
Introduction to Diversification
Diversification is the process of spreading our investment across different asset classes or investments and there by not putting all the eggs into a single basket.
The most common form of diversification is the one based on asset classes - Debt and Equity.
Within debt, we can diversify our investments into various asset classes like bank fixed deposits, PPF, bonds, debentures etc.
Within equity shares, we can do diversification based on market capitalizations, across sectors and industries etc.
To achieve good diversification, we can consider a 2-dimensional matrix of market capitalizations on one axis and sectors / industries on the other.
Further, we can use a passive core portfolio and an actively managed non-core portfolio.
Read on to know what is a core portfolio and what is a non-core portfolio.
What is a Core and Non-core Portfolio?
In the process of portfolio building, we need to have two parts in our portfolio
- core portfolio for long term and
- non-core portfolio for short / medium term
That is an important step in building a portfolio.
Portfolio means a basket of company shares
Our portfolio can be seen from our demat statement.
Your Demat Account Statement provided by the broker is like a basket.
Like the fruit basket, we fill our portfolio with shares of different companies from different sectors / industries.
What exactly is a Sector and Industry?
We often use the terms sectors and industries interchangeably.
However, there is a small difference between the two terms.
A Sector refers to a large segment of the economy
An Industry describes a much more specific group of companies or businesses.
For example, The 'Finance' sector can comprise of industries such as 'NBFCs', 'Life Insurnace', 'Asset Management' etc.
Some ever green sectors
Now let us come back to the topic of portfolio building.
Some ever green sectors that will do business in all market conditions are:
- Autos (2 Wheelers / 3-wheelers / commercial vehicles etc)
- Banking / Finance (including NBFCs)
- IT (includes BPOs)
- Pharmaceuticals (and health care)
- Power (includes Energy companies)
Please note: This is an indicative list and not a recommendation. The list of sectors depends on individuals risk appetite and perspectives about the sector.
Assume that we have invested only in one company, say XYZ Bank.
If the share price of this company goes up, you will be happy since you will be in gain.
But, if the share price goes down, you will sit on a loss.
This means that we have a high dependency on the performance of XYZ Bank so as to make gains.
This is not a good strategy because all our fate lies on the performance of this single company.
In order to reduce dependency on a single company, we will invest in two or more companies.
By doing this, we are spreading our risk and dependency across two or more companies.
So, diversification helps us in enhancing risk-adjusted returns.
In general, when the market goes up, not all stocks in the stock exchange go up.
Some may go up while others actually go down.
So, if you keep investing, over a period of time, you will notice that some of your investments went up while others came down when you compare them with what you had a year ago.
To minimize high dependency on one company share / sector, we need to *Diversify*
- Diversification* can be done by doing two things:
1. Investing in different company shares from different sectors.
2. Maintaining a proper balance of weightage of each of the companies
How many companies can our demat hold?
Now, a Question for you all:
In general, How many stocks are we allowed to hold in demat?
How many listed companies are there on Indian stock exchanges?
There are thousands of listed companies.
Technically, there is no limit for the number of shares nor the quantity of shares that you can hold in the demat.
How many stocks can we buy with the money we have in our bank account right now?
Very few! Right?
Amongst several thousands of stocks available in the market, very few stocks will qualify our filtering criteria.
We already have limited our long term investments into Top 500 companies.
We follow some simple rules and invest in companies that meet a certain criteria:
Dividend paying, profit generating, consistent company performance, good traded volumes etc.
So, what we have to do is, we have to cheery pick carefully.
Another important thing is that:
A simple look at the top 10 stocks shows that not all stock go up or down in the same direction all the time.
What we have to do is:
Have a mix of up trending stocks + some down trending stocks (but those that have a potential to go up in future).
With a proper mix of sectors and industries, we can reduce the risk and dependency on one company / sector.
This means, as we keep adding more companies (from different sectors) to our portfolio, the risk attached to our investments reduces.
Hence, sectoral diversification is a good risk management tool.
One important term worth mentioning here is Contra stocks
Stocks that move in the opposite direction to the broader index are called Contra stocks.
How many companies to invest in?
Apart from our money, we invest time in researching and studying stocks.
Once invested, we need to know every news, event and update related to the stocks we hold.
So, it will be wise to hold a handful or limited number of stocks as part of core-portfolio stocks for the long term ..
and perhaps 3 to 5 as non-core-portfolio stocks for the short term.
Studies have shown, holding 8 to 13 is sufficient to build a diversified portfolio.
My experience is that more than 5 will be difficult to track and get to know because of time and other reasons on a daily basis.
If possible, maintain an Excel file tracking all major activities of each of the stock / sector on a daily basis.
I will explain about creating Excel template to track portfolio in later classes.
So, the rule we are framing today is related to diversification
- Rule #21: Diversify your portfolio to a maximum of 5 to 10 stocks with a proper mix from different sectors / industries
Assignment - Core Portfolio Building
Now, here is something you have to do
1. Find one fundamentally good share from the following sectors
Autos (2 Wheelers / 3-wheelers / commercial vehicles etc) Banking / Finance (including NBFCs) IT (includes BPOs) Pharmaceuticals (and health care) Power (includes Energy companies)
2. Try to apply as many of our rules as possible on the shares.
Assignment: Sectors of our invested companies
1. Take your demat account statement.
2. Visit BSEIndia.com and search for the stock name
3. Note down the Group / Index and the Industry to which it belongs
Assignment: Model Portfolios
Those who have time, collate model portfolios from different brokerage houses and see how they perform. Compare the weightages that they allocated for each sector with that of yours. Try to find out the rationale between additions and removal of companies in their model portfolio. If you feel their reason is valid, consider making appropriate changes to your portfolio.
Companies like ICICI Direct, CLSA etc regularly release them.
You can download them from MoneyControl or DeadPresident.blogspot.com
Question: Three banking stocks
Can we hold these three stocks in a long term portfolio?
SBI, HDFC Bank and HDFC Ltd
Why? and Why not?
Ignore the company share price, financial factors etc.
Decide based on Diversification.
International Classification of Industry Sectors (for Investing)
If you are a portfolio manager with clients spread across the globe, your clients might insist you classify industries based on international classification standards.
Some sector / industry names based on International classification are:
- Basic Materials - Communication Services - Consumer Cyclical - Consumer Defensive - Energy - Financial Services - Healthcare - Industrials - Real Estate - Technology - Utilities
Considering that there are different naming forms for sectors and industry, MSCI and Standard & Poor has developed a naming standard called Global Industry Classification Standard (GICS)
GICS has developed a global standard for naming sectors, industry groups, industries and sub-industries.
Its classification has:
11 Sectors 24 Industry Groups 68 Industries 157 Sub-Industries
Here is the list of sectors:
Energy Materials Industrials Consumer Discretionary Consumer Staples Health Care Financials Information Technology Telecommunication Services Utilities Real Estate
For more information, read https://en.wikipedia.org/wiki/Global_Industry_Classification_Standard
What are the uses of following GICS?
1. Helps you build portfolios that follow world-class classification standards
2. Reduced overlap of companies by careful selection of sectors
3. Useful by Chartered Accountants and Company Secretaries who are involved in professional reporting
4. Helps when you work as an analyst with a brokerage company when you are involved in stock / sector reviews.
Assignment on GICS Classification
Take our Mega List of Stocks or any model portfolio and try to classify the list of companies in the list under the GICS-naming standard.
Assignment: Long Term Portfolio Planning
Here is a question from a reader: Following is the state of my current portfolio. In the recent market sell-off, some of my best performers have suddenly turned negative. Not that I'm worried as I'm focused on the long term and do not plan to sell-off any of my equity investments. However, the portfolio is highly skewed. Would appreciate if the valued forum members can provide their input on how to rebalance this portfolio.
- PIDILITE 10%
- ASIAN PAINTS 10%
- NESTLE 9%
- LUPIN 6%
- SUPREME INDUSTRIES 5%
- KAJARIA 5%
- HAVELLS 5%
- INDIGO 4%
- BRITANNIA 4%
- S H KELKAR 4%
- SUZLON 4%
- HDFC 4%
- KOTAK MAHINDRA BANK 4%
- MT EDUCARE 4%
- GRUH FINANCE 3%
- TTK PRESTIGE 2%
- JUBILANT FOODWORKS 2%
- ITC 2%
- TCS 2%
- SYNGENE 2%
- AMARA RAJA 1%
- How would you rate this portfolio from 1 (worst) to 10 (best)? As I said, my outlook is for the long term (>5 years atleast).
- Would like to increase exposure to IT (Buy Infy) and Auto (Add to Amara Raja or Buy Atul Auto).
- Given that I have three holdings in the BFSI sector, which would be the best to increase in amount? Or should I increase my holdings in the BFSI sector proportionally?
- Should I prune my portfolio in terms of the number of shares?
Unfortunately, Over-diversification is a very common problem with most equity portfolios.
In fact, it is one of the most common mistakes that investors do.
Investors keep looking for stock names and targets and if some fancy story appears interesting, they just buy it and hardly follow up later.
The enthusiasm soon wades off and the stock remains in the portfolio as a dead weight unless the stock price keeps moving up from Day 1.
It is always important to limit the diversification activity to those many companies that you can easily track.
An easy way of testing your abilities to track stocks is to name as many names as possible from your portfolio and their closing prices.
Additional Reading Reading
- Qualitative factors of company in stock investing
- Quantitative factors of company in stock investing
- Market Capitalization
- Sales Growth of Company
- Debt-free / Low-debt / Virtually-debt free companies (Rule 10)
- High Beta Stocks (Rule 24)