How To Make A Robust Portfolio

In this article Bhavya Rathod delves into the technical aspects of constructing a strong equity portfolio in the indian market, equipping investors with valuable insights to optimise their investment strategies.

In life, we often find that everything functions more effectively when it is balanced and wholesome. Take, for instance, the importance of a balanced diet that incorporates all the essential nutrients. It is widely recognised that such a diet promotes better health and wellbeing compared to an unplanned or unbalanced one. Similarly, in various aspects of life, whether it’s maintaining physical fitness or excelling in academic pursuits, the emphasis is often placed on being well-rounded or balanced. This principle of balance extends to the realm of investing as well. 

Just as a diversified portfolio helps to optimise asset allocation, a robust portfolio ensures that our investments are harmoniously structured to meet our financial goals. By maintaining a balanced approach to investing, we can strive for an optimised mix of assets and enhance the potential for long-term success. The Indian equity market offers immense growth potential, but investors must navigate its inherent volatility and risks to build a robust portfolio. Crafting a robust equity portfolio in the Indian market context requires a systematic approach, encompassing diversification, rigorous fundamental analysis, risk management and vigilance towards market trends.

Constructing a Robust Equity Portfolio

Constructing a robust equity portfolio in the Indian market requires a meticulous approach that incorporates all the factors mentioned above. By adhering to these technical principles, investors can position themselves for sustained growth, capitalise on market opportunities and navigate the dynamic landscape of the Indian equity market. Here’s how you can start to construct a robust equity portfolio:

Define Your Investment Objectives

Before delving into the construction of an equity portfolio, it is vital to define your investment objectives. Are you seeking capital appreciation, dividend income or a combination of both? Understanding your objectives will shape your investment strategy and guide your decision-making process as you select stocks that align with your goals. By taking the time to reflect upon and define your investment objectives, you lay the foundation for a strategic and purposeful portfolio construction process. Your investment goals will serve as a guiding light, influencing the choices you make and the strategies you employ when selecting stocks that align with your aspirations. 

Understanding your objectives not only provides clarity to your investment journey but also enables you to make well-informed decisions that are in harmony with your desired outcomes. Remember, the process of constructing an equity portfolio is not merely about accumulating a random assortment of stocks. It is a purpose-driven endeavour that requires careful consideration and alignment with your investment objectives. By defining your objectives at the outset, you set yourself on a path towards building a portfolio that is tailored to your needs and aspirations, maximising the potential for success in the dynamic world of equity investments.
 

Assess Your Risk Tolerance

When venturing into equity investments, it is essential to recognise and acknowledge the inherent risk that accompanies the potential for substantial rewards. The dynamic nature of the stock market exposes investors to fluctuations that can impact the value of their holdings. Therefore, it becomes paramount to conduct a thorough assessment of your risk tolerance, taking into account various factors such as your age, financial situation and personal preferences. Assessing your risk tolerance serves as a fundamental step in constructing a robust equity portfolio that aligns with your individual circumstances and comfort level.

It involves a thoughtful examination of your ability to withstand market volatility, potential losses and fluctuations in the value of your investments without experiencing undue stress or compromising your long-term financial objectives. Consider your age when evaluating your risk tolerance. Younger investors typically have a longer investment horizon and may be more inclined to tolerate short-term market fluctuations in pursuit of higher long-term returns.

Conversely, individuals approaching retirement or relying on their investments for near-term financial goals may have a lower risk tolerance and prioritise capital preservation over aggressive growth. Your financial situation also plays a significant role in assessing risk tolerance. Factors such as income stability, debt levels and liquidity requirements should be taken into consideration. Investors with stable income and ample liquidity may have greater flexibility to tolerate higherrisk investments, while those with limited resources or financial obligations may opt for a more conservative approach.
 

Conduct Thorough Fundamental Analysis

In the process of constructing a robust equity portfolio, one cannot underestimate the significance of fundamental analysis when selecting individual stocks. It is a crucial step that demands thorough evaluation of a company’s financial health and performance, encompassing various essential factors that provide insights into its potential for sustained growth and success. When conducting fundamental analysis, it is imperative to delve deep into the intricacies of a company’s financials. This entails scrutinising its revenue growth trajectory, examining the stability of its earnings and assessing the levels of debt it carries. 

Understanding a company’s financial health provides a solid foundation for making informed investment decisions, as it offers valuable insights into its ability to generate consistent profitability and manage its financial obligations responsibly. Key financial ratios serve as vital indicators of a company’s financial strength and performance. These ratios, such as the price-toearnings ratio (PE), debt-to-equity ratio (DE) and return on equity (ROE), provide quantitative metrics that can be compared across companies and industries. Analysing these ratios enables investors to gauge a company’s valuation, its leverage levels and the efficiency with which it utilises its shareholders’ equity

Such analysis helps identify companies that exhibit favourable financial metrics, suggesting strong fundamentals and the potential for long-term growth. Moreover, fundamental analysis extends beyond financial metrics alone. It necessitates a comprehensive examination of industry trends, competitive advantages and future growth prospects. Understanding the industry dynamics in which a company operates is crucial for evaluating its competitive position and assessing the potential for sustained growth. Identifying companies that possess unique competitive advantages, such as proprietary technology, strong brand recognition or significant market share, can provide a competitive edge and contribute to long-term success.
 

Diversify Across Industries and Market Capitalisations

The principle of diversification stands as a cornerstone when constructing any portfolio and its significance extends to the realm of equity investments. By spreading investments across different industries and market capitalisations, investors can effectively reduce the potential impact of any single stock’s performance on the overall portfolio. Thus, diversification serves as a powerful risk management strategy that aims to optimise returns while mitigating the inherent volatility and uncertainties associated with individual stocks. One aspect of diversification within an equity portfolio is the allocation across different market capitalisations. 

Market capitalisation refers to the total value of a company’s outstanding shares and is an indicator of its size. By including a combination of Large-Cap, Mid-Cap and Small-Cap stocks in the portfolio, investors can capture growth opportunities across different segments of the market. Large-cap stocks, typically representing well-established companies with stable operations, provide stability and potential dividend income. Mid-cap stocks often offer a balance between growth potential and a certain level of stability, while small-cap stocks, representing relatively smaller companies, can offer the potential for significant growth but also carry higher levels of risk. 

This diversified approach across market capitalisations helps balance risk and reward, allowing investors to benefit from the potential growth of companies across various stages of development. Furthermore, diversification across sectors is crucial to mitigate sector-specific risks and capture opportunities from different segments of the economy.

Different sectors tend to perform differently under varying economic conditions, as each industry is influenced by unique factors. By spreading investments across sectors such as technology, healthcare, consumer goods, financials, and others, investors can reduce the impact of any single sector’s performance on the overall portfolio. 

This approach helps ensure that potential losses from underperforming sectors are offset by gains in other sectors, thereby enhancing the portfolio’s stability and reducing concentration risk. Investors with longer investment timeframes, such as 10 years or more, and a higher tolerance for risk, may find it beneficial to allocate a portion of their portfolio to small-cap stocks. However, for a shorter investment horizon of 5-7 years, it would be more suitable to focus on large-cap funds. Including mid-cap stocks alongside large-cap stocks is advisable for a well-rounded portfolio.

In the case of conservative investors who typically have a minimal allocation to equities, they can allocate their entire equity portion to 100 per cent large-cap stocks as it aligns with their cautious approach. Balanced investors, aiming for a moderate approach, can consider incorporating non-large-cap stocks into their portfolio. This can be achieved by allocating around 70 per cent to large-cap stocks with the remaining 30 per cent allocated to mid-cap stocks. On the other hand, aggressive investors who are willing to take on higher levels of risk may opt for a more aggressive strategy. In this case, they should assign the majority of their portfolio, preferably 30 per cent each, towards mid-cap and small-cap stocks and 40 per cent should be allocated to large-cap stocks. 

In order to illustrate the performance of the three mentioned portfolios (conservative, balanced and aggressive), we have compared their performance with that of the large-cap, midcap and small-cap sectors from 2005 to 2023 on year-to-date basis.

A total investment of ₹100,000 was made in each of the portfolios at the beginning of 2005. By the end of 2023 (YTD), the conservative portfolio yielded a total of ₹9,05,069.9, the balanced portfolio amounted to ₹10,52,587 and the aggressive portfolio reached ₹11,32,090. These figures represent respective returns of 11.96 per cent, 12.83 per cent and 13.25 per cent. It is evident that over the extended period, the aggressive portfolio outperformed both the conservative and balanced portfolios,generating additional alpha.
 

Rebalancing

Periodic rebalancing of your equity portfolio is crucial to maintain the desired asset allocation and capitalise on investment opportunities that arise in the market. As some stocks outperform while others underperform, your portfolio’s allocation may deviate from your original strategy. Rebalancing involves selling a portion of over-performing stocks and reallocating the funds into under-performing stocks or new investment opportunities to restore the desired balance. Rebalancing not only helps manage risk but also allows you to take advantage of market inefficiencies.

By trimming positions that have experienced substantial gains, you can lock in profits and reduce exposure to potential downturns. These proceeds can then be reinvested in assets that have strong growth prospects or appear undervalued, offering the potential for future appreciation. Keep in mind that rebalancing should be approached as a disciplined process rather than a reaction to short-term market volatility. Establish a predetermined schedule for rebalancing, such as quarterly or annually, and stick to it unless there are compelling reasons to deviate from the plan. 

Regularly reviewing your portfolio’s performance and consulting with a financial advisor can help ensure that your rebalancing decisions are based on solid analysis and align with your overall investment strategy. To minimise the overall expenses incurred through brokerages and taxes, it is advisable to opt for an annual schedule for portfolio rebalancing. One notable example of rebalancing in the context of equity portfolios is the rebalancing process of the Nifty index. The Nifty index is periodically rebalanced to ensure that it remains representative of the market and reflects the current market conditions. The rebalancing process involves adjusting the weightage of individual stocks in the index based on predefined criteria.
 

Integrating Performance Metrics

Sharpe Ratio — The Sharpe ratio is a widely used performance metric that assesses the risk-adjusted returns of an investment. It quantifies the excess return generated per unit of risk taken. A higher Sharpe ratio indicates a more favourable risk-return trade-off. When constructing an equity portfolio, selecting stocks with higher Sharpe ratios can potentially enhance risk-adjusted returns and mitigate downside risk. In the context of the aforementioned portfolio example, the yearly Sharpe ratios for all the three portfolios are relatively close, with the balanced and conservative portfolios having slightly higher ratios of 0.57 each compared to the aggressive portfolio which stood at 0.54. This suggests that all three portfolios have exhibited reasonably good risk-adjusted performance.

Sortino Ratio — While the Sharpe ratio considers overall volatility, the Sortino ratio focuses on downside volatility. It measures the excess return generated per unit of downside risk. By using downside deviation instead of total deviation, the Sortino ratio offers a more refined evaluation of risk-adjusted performance. Incorporating stocks with favourable Sortino ratios can help investors target investments with lower downside volatility. In the context of the aforementioned portfolio example, the yearly Sortino ratios indicate that the conservative portfolio has the lowest downside volatility with a ratio of 1.24 compared to the balanced and aggressive portfolios, which stood at 1.28 and 1.29 respectively, implying better risk management in terms of minimising downside risk.

Managing Maximum Drawdown — Maximum drawdown refers to the largest peak-to-trough decline experienced by a portfolio over a specific period. It indicates the extent of loss an investor would have endured during the portfolio’s worst downturn. Managing maximum drawdown is crucial for preserving capital and avoiding substantial losses. By diversifying across different stocks, sectors and asset classes, investors can reduce the impact of any single stock or market segment on the portfolio’s overall performance and mitigate the risk of significant drawdown. In terms of the aforementioned portfolio example, the aggressive portfolio has experienced the highest volatility, as reflected by the larger average drawdown and higher maximum drawdown of -35.90 per cent and -61 per cent compared to the other portfolios.
 

Conclusion

As witnessed in the portfolio example, the conservative portfolio has demonstrated a higher win year percentage, indicating higher consistency of positive returns over the years compared to the balanced and aggressive portfolios. The conservative portfolio also has a lower average drawdown and average drawdown days, suggesting potentially quicker recoveries from losses. The conservative portfolio may appeal to investors seeking a more conservative approach with lower volatility and a focus on capital preservation. It has exhibited relatively stable returns and lower drawdown.

The balanced portfolio strikes a balance between risk and reward, with moderate returns and volatility. The aggressive portfolio has the potential for higher returns but comes with greater volatility and larger drawdown. It may be suitable for investors with a higher risk tolerance and a long-term investment horizon. Hence, the manner in which spices are incorporated into one’s diet is a matter of personal preference. Neither of the aforementioned approaches is universally deemed as superior. It ultimately depends on an individual’s personal choices and preferences when constructing a portfolio.

If an individual has a stronger inclination towards large-cap stocks, it would be advisable for them to build their portfolio accordingly. Similarly, the decision to include mid-cap and small-cap stocks is also based on an individual’s personal preferences. Constructing a robust equity portfolio requires careful planning, diligent research and ongoing monitoring. By defining your investment objectives, assessing risk tolerance, conducting thorough fundamental analysis, diversifying across industries and market capitalisations, blending growth and value stocks, considering dividend-paying stocks, monitoring and reviewing your portfolio, rebalancing strategically and seeking professional guidance when needed, you can build an equity portfolio poised for long-term growth and financial success. 

Remember, building a robust equity portfolio is a journey that demands patience, discipline and adaptability. Stay informed about market trends, regularly review and adjust your holdings, and make informed decisions based on sound investment principles. With a well-constructed equity portfolio, you can harness the power of stocks to generate wealth and achieve your financial goals over the long run. If necessary, seek the guidance of a qualified financial advisor to ensure that your investment decisions align with your objectives and optimise your chances of success.