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PR Newswire
01-11-2023, 09:34 AM
According to Modern Portfolio Theory (MPT), the risk (volatility) of the portfolio is reduced if the stocks are lowly or even not correlated. MPT has a formula using variances and covariances to determine the risk of a portfolio.
The challenge with the MPT approach is that variances and covariances are not stable. And if you go beyond a few stocks, the computing power required is beyond most retail investors. Worse still if you are constructing a portfolio based on a stock picking approach.
Rather than try to compute the portfolio volatility, I tried to ensure that my stocks are lowly or not correlated from the start. This meant that in selecting the stocks, I look for those in different sectors, size (market cap), countries and even business conditions (eg turnaround, growth, cyclical).
In practice this meant that I view my portfolio as a collection of stocks with over-lapping characteristics (sector, size, etc). Then I have a rule of thumb where I cap the % contribution of a group within a particular characteristic.
For example, I would have a 30% limit for stocks from a certain sector. Then it is 30% max for stocks in a certain stock exchange and so on.
You can imagine the challenges. First, you may have to ignore stocks of the same countries even if they are the better ones. Secondly, you need to widen your circle of competence. And the 30% is set arbitrarily.
Do you have a better approach to ensure diversity in you stock portfolio?
For more insights go to “Baby steps in constructing a stock portfolio”
The challenge with the MPT approach is that variances and covariances are not stable. And if you go beyond a few stocks, the computing power required is beyond most retail investors. Worse still if you are constructing a portfolio based on a stock picking approach.
Rather than try to compute the portfolio volatility, I tried to ensure that my stocks are lowly or not correlated from the start. This meant that in selecting the stocks, I look for those in different sectors, size (market cap), countries and even business conditions (eg turnaround, growth, cyclical).
In practice this meant that I view my portfolio as a collection of stocks with over-lapping characteristics (sector, size, etc). Then I have a rule of thumb where I cap the % contribution of a group within a particular characteristic.
For example, I would have a 30% limit for stocks from a certain sector. Then it is 30% max for stocks in a certain stock exchange and so on.
You can imagine the challenges. First, you may have to ignore stocks of the same countries even if they are the better ones. Secondly, you need to widen your circle of competence. And the 30% is set arbitrarily.
Do you have a better approach to ensure diversity in you stock portfolio?
For more insights go to “Baby steps in constructing a stock portfolio”