How to put together a diversified stock portfolio

By Odhiambo Ocholla

The Nairobi Stock Exchange (NSE) has started showing signs of recovery thus investors should be now more confident than ever about investing in shares.

But importantly, investors need to construct a winning portfolio. The key to being successful is to practise good portfolio management.

There are two critical areas investors need to consider when constructing a portfolio—managing risk, and money management.

Asset allocation is the most important decision when managing overall portfolio volatility. For example, a measured blend of stocks, bonds and cash tends to provide a higher level of return per unit of risk exposure than an all-stock portfolio.

Consequently, it is better to reduce the overall risk of an all-stock portfolio by allocating part of the portfolio to bonds rather than by trying to invest only in less-volatile stocks.

Managing equity portfolio risk

After targeting your overall portfolio risk level via asset allocation, investors can turn to managing risk within their individual stock portfolio.

The primary objective is to manage volatility relative to your benchmark so that your stock portfolio generally moves with or "tracks" the stock market.

To reduce relative risk, investors are advised to align their portfolio with their benchmark along the two most critical dimensions of relative risk— company

size and company sector

While it is true that diversification reduces risk, a portfolio of shares that is over-diversified is exposed almost exclusively to market risk, which cannot be eliminated by diversification. Therefore, the market risk remains regardless of the degree of diversification of the portfolio. However, an investor must also contend with specific risk, which refers to the risks inherent in a company or particular events in a sector that influence specific securities.

The total risk, therefore, is the sum of the market risk and the specific risk of the individual positions.

Obviously, the specific risk is very high if you invest in only one stock, but the more a portfolio is diversified, the less the specific risk.

It is advisable for investors to hold a smaller number of shares to actively manage the specific risk.

If you are an investor who does not have the time to manage the specific risk, then holding a portfolio of few shares will enable you reduce volatility without dramatically reducing returns.

Increasing your holdings beyond certain numbers of shares exposes the portfolio to market risk, which cannot be eliminated by diversification.

Firm size as a risk dimension

Equity market indexes are usually capitalization weighted, meaning that a Sh20 billion stock's contribution to an index's return is 10 times that of a Sh2 billion stock. The market's top-heavy capitalisation profile has huge practical implications for constructing a portfolio that tracks the NSE 20 Index.

For simplicity, most investors tend to hold portfolio positions of approximately equal size. The stock market can also be decomposed by sectors/industries.

This is important because stocks within the same sector often move together, while the sector groups themselves often move somewhat more independently.

As a result, two portfolios with the same number of stocks can perform very differently if their sector compositions differ.

Wealth Management strategy

Obviously, if you want to improve the returns you get in your portfolio, it makes sense to simply get rid of the stocks that are going down. After all, every investor want to hold stocks that are rising in price.

But the bottom line is that if investors are to remove the shares that are falling in price, their overall returns should be much better. Obviously, this is because the shares falling in value are eroding the gains of the shares rising in price.

The second critical area in constructing a portfolio is money management. Regardless of types of investor, money management is critical to your success in achieving good returns on the portfolio.

Of course, if you do not have the capital or commitment to construct and manage a large stock portfolio, mutual funds or unit trust funds can be fine alternatives.