Thread by @itsTarH

Its the weekend!

Grab a cup of coffee ☕

In this thread we will talk about Portfolio Construction

1⃣ Factors that determine how a Portfolio should be constructed
2⃣ Different types of PF construction methodologies
3⃣ Why Portfolio Principles matter?

Lets dive right in.

Before you start picking stocks and sectors to invest in, you should be asking yourself a few very important questions.

1⃣ What is my End Goal from Investing?
2⃣ What is my Risk Profile?
3⃣ What is my Time Horizon?

Answering these four questions will help you build the foundation to your portfolio construction progress.

And, we all know, without a good foundation, no structure can stand tall!

1⃣ What is my End Goal from Investing?

The answer to this question is important.

Your end goal determines, how much risk you need to take and what should be your time horizon.

Not everyone has the same goal.

Maybe someone is investing to accumulate enough capital to pay for their post grad, or down payment on a house while others maybe investing for their retirement.

The bottom line is everyone's goals and expectations from investing are different.

That's why when people copy investment ideas without research and seek advice from social media handles, they are doing a great disservice to themselves and their hard earned money.

Take for example, Mr.A

He is 21 years old, has a few lakhs in capital, just graduated from college and employed in his first job.

To him, his main goal is to accumulate 15 lakhs so that he can pay for his MBA on his own.

Meanwhile, there is Mrs. B

She is a 45 year old lady, nearing retirement and has a few crores of saved up capital.

Her main goal is to protect this capital while seeking 10-12% returns to beat inflation and protect her purchasing power.

Both Mr.A and Mrs.B are investing in the same market, using the same platform to invest, pay same fees to invest, yet their goals are as different as they can be.

A portfolio construction approach for Mr. A is not suitable for Mrs. B and visa versa.

2⃣ What is my Risk Profile?

Once, you have decided your goals from investing, you can move on to determining your Risk Profile.

At this stage, you need to get familiar with two important concepts.

1⃣ What is my Risk Capacity?
2⃣ What is my Risk Appetite?

Risk Appetite is the amount of risk you are *WILLING* to take

while

Risk Capacity is the amount of risk you can *ACTUALLY* take

Combined, both will tell you about your Risk Tolerance.

If you have ever used a Robo Advisory or any Investing app, it will ask you a bunch of questions at the time of onboarding.

The questions range from your net worth, salary, dependents, existing insurance etc.

What the app is trying to do is estimate your Risk Capacity.

For example, you have net worth of a few crores, no dependents, have good life and health insurance and earn a stable well paying salary.

But your investments are only in fixed deposits and you tend to stay away from any investment that doesn't guarantee a return.

In the above example, the Risk Capacity for the individual is high but Risk Appetite very low.

There is a mismatch and as such they need to realign.

3⃣ What is my Time Horizon?

This is the final question to ask yourself before you can begin constructing your portfolio.

Time Horizon, determines the kind of assets you can invest under.

If your investment horizon is one year, risk capacity low and target return is 7%, then equity investing isn't for you.

Similarly, if your investment horizon is ten years, risk capacity high and target return is 15% per year, then you probably want to invest in equities.

Time Horizon of 1 year and expectation of 100% returns are unrooted in reality and probability of achieving these without taking on significant risk is bizarrely low.

The above three questions are the key factors to decide upon before you can even begin to construct your portfolio.

Lets now understand the different types of Portfolio Construction Methodologies.

There are three main types of Portfolio Construction Approaches.

1⃣ Conservative or Income Producing
2⃣ Aggressive or Growth Oriented
3⃣ Barbell Approach

Lets explore a bit about each and how to determine the right one for you.

Every portfolio is different in its own right and should reflect the return and risk profile of its owner.

Like in our example from earlier, Mrs. B wanted to preserve her capital rather than grow it and since she was aiming for retirement, she may need to supplement her income soon.

In her case a low beta dividend generating portfolio that just beats inflation is more suitable compared to a high beta growth oriented one.

Similarly, our friend Mr. A who was looking to build enough corpus to pay his MBA fees needs an aggressive growth oriented portfolio simply cause his return requirement and risk capacity are high.

I observe so many people trying to create a Portfolio for the sake of it.

They want dividend stocks, they want multibaggers, they want speculative assets and they even want IPOs.

Why?
I am not sure if they know.

Filling too many random stocks in your portfolio without any strategy or reasoning is similar to a house that is overfilling with junk and no place for owners to reside .

Without establishing risk vs return goals, you are just shooting in the dark.

There is a lot more to Portfolio creation, than just conversations around concentration vs diversification.

Another approach to portfolio creation is called the Barbell Approach.

At one side of the portfolio you load up stable low beta income producing stocks.

These can be your ITC, HCLs of the world.

At the other end of the Barbell you load up high beta growth stocks, like Borosil Renewables, Laurus Labs, CDSL etc.

What this does is reduces the overall risk in your portfolio while giving you a stable upside.

In times of distress, Barbell portfolios perform much better than your traditional hybrid, conservative or aggressive funds.

A question I presume, I will get is what is the difference between a Barbell Approach vs a Hybrid or Balanced Mutual Fund

Barbell approach doesnt invest in any debt, its purely an equity portfolio where as Balanced Mutual Funds try to time the market to an extent

Barbell doesnt

The final part of this thread will talk about Principles.

Equity investing is hard, not cause its complicated but because emotions are involved.

Emotions tend to screw things and investors usually need a North Star to guide them in times of severe distress.

Writing down your principles, before you start investing will help you in times when emotions of greed and fear run high.

They will act as your North Star.

I have talked about my personal investing Principles at great length in the below thread.

Please consider following the same exercise for yourself.

So, those were the basics of Portfolio Construction.

How did you construct your portfolio? Leave a comment below.

With this, we come to an end of this thread.
I hope this thread helped you understand the topic better.

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I write a new thread every weekend.

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Thank you for reading see you all next weekend.