As an amateur investor, do you wonder why your portfolio returns are so average when many of your stocks are flying? The answer could lie in portfolio weights or position sizing.     

While stock traders use position sizing as a risk-control measure, conscious position-sizing is important for fundamental investors too. Amateur investors are prone to the mistake of not backing their good ideas with meaningful weights. When you own a 50 or 100-stock portfolio with many holdings at 1-2 per cent weights, even a stock going up five-fold will not make a big difference to your returns.

So, how should you, as a fundamental investor, decide on stock weights? Here are some approaches.

Equal weights

Some professional investors believe that the best way to position-size is to equal-weight stocks in their portfolio. If they plan a 20-stock portfolio, they allocate 5 per cent of their capital to every buy. This approach, apart from being simple, ensures that only their best ideas make it to the portfolio and carry meaningful heft.

Equal weighting can work for professional fund managers who have a fixed corpus to manage. They can screen the universe for their 20 best ideas and distribute weights equally.  

But equal weighting poses practical difficulties for retail investors, who build their portfolios one stock at a time. When they start investing, they do not know how many good stock ideas they’ll find. They have varying conviction levels about each pick. 

Retail investors can start out by setting a maximum weight for individual stocks, as a risk-control measure. Suppose you have a ₹10 lakh equity portfolio and losing ₹1 lakh on a position will keep you awake at nights. You can set an upper limit of, say, 7 per cent (₹70,000) on your individual stock purchases.    

Volatility

As an investor, your objective may be to reduce upheavals at the portfolio level. Using stock price volatility to assign weights can help you achieve this.

If you are looking to add Suzlon Energy and Marico to your portfolio, you try to gauge their stock price volatility using past data. The 52-week range of the stock can be a rough indicator. So, if Suzlon has swung between ₹6.6 and ₹27 in the last one year while Marico has stayed between ₹462 and ₹590, you assign a lower weight to Suzlon and a higher one to Marico.

But a more scientific approach would be to download historical prices of the two stocks over the last 10 years and work out their daily and annual standard deviation in excel. You can then assign a higher weight to the stock with lower standard deviation and vice versa.

While this approach can help smooth out your portfolio returns, do note that it makes no distinction between upside and downside volatility. As investors, we may be unsettled by a stock falling 70 per cent in a year, but we may not mind it if it shoots up 300 per cent!

Business, management, valuation

When assessing any stock’s fundamentals, investors usually look at business prospects, genuineness of the management and its valuation. Indeed, many mutual fund managers follow this three-pronged approach.

If a stock scores high on all three variables, you need not hesitate to allocate your maximum weight at one go. But in practice, when hunting for stocks you’ll find that very few score high on all three parameters. A company with a good growth runway and respected management will often trade at a nose-bleed valuation. Or if you find a company with good management trading at a modest valuation, it is because the business is mired in a slump.

In such cases, instead of taking yes-or-no decisions and missing out on the opportunity, you can play around with stock weights. You can assign a 1 per cent weight to a company that is going through a rough patch, but has good management and prospects. You can promote it to 3 per cent if and when the business improves. If a stock has sound business and management but is pricey, you can start at a 3 per cent weight. You may take it up to 7 per cent when it corrects.

Conviction

Even if you are not so systematic with your research, your stock weights can reflect your conviction levels. If you’re buying a stock because you know the business like the back of your hand and are convinced about its return potential, you can allocate your maximum weight to it. If you’ve spotted a good idea but are still researching it, you can acquire a tracking position of 2 per cent and add to it as you gain conviction. For a stock you bought on a whim as a trading bet, you can stick to a 1 per cent weight.

Finally, do remember that as your capital invested in equities grows, your positions need to keep up. If you invested ₹70,000 on your best ideas when your portfolio was at ₹10 lakh, you need to consciously treble it when it has grown to ₹30 lakh.  

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