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The Diversification Hot Seat

Investors must decide whether they want to chase quick gains, taking huge risks, or look for safe and stable gains

The machinery of a bull run has started working again. While the pundits are talking about the extent of the recovery and the monsoon recovery and the flows and the whatnot, the punter can feel it in his bones. Every day, the brokers' boys (relationship managers, in modern language) call armed with the results of their 'research', and almost miraculously, they are right. They say a stock will move and it does move. It's almost like the good old days of 2006 and 2007 once more.

However, there's always an however. Last time around, when things started to go wrong, first in mid-2007 and then later in January, 2008, these momentum stocks were the ones that caused the deepest grief to investors. The reason is very simple. Selecting investments in this fashion invariably results in a portfolio that's composed largely of mid- and small-cap momentum stocks. These are the only type of stocks that can produce large movements quickly enough to satisfy the expectations of gains that come with the trading mindset. Not just that, such portfolios are typically also concentrated in whatever is the hot sector of the moment. Last year, more traders' were trapped into huge losses in the real estate counters than any other.

Now that we're seeing the beginning of another heady phase, there is a danger that along with the hot gains, we'll also get the same set of problems. The solution is also simple - while it's great to make money in the hot stocks, the basics of portfolio construction cannot be forgotten. And it goes without saying that the most important principle of portfolio construction is that of diversification. Diversification across companies, across sectors and across capitalisation. While an individual investor should not be expected to get into the portfolio construction theories, some basic rules of thumb should be followed.

Here are my suggested thumb rules to ensure that at least a minimum discipline is maintained:

* Own at least 10 stocks. The largest holding should be at most 15-20 per cent and the smallest no less than 5 per cent of the total;

* Own stocks in at least 3 distinct sectors, with no single sector taking up more than half of your portfolio;

* Do not have exposure only to smaller companies. Make sure that at least around half of your equity exposure is to BSE 100 companies. Alternatively, you could keep about that much of your equity exposure in a good diversified equity mutual fund that is focused on large-cap stocks.

Make sure you maintain the above rules dynamically. When changes in stock prices can take you beyond these limits, you must rebalance your portfolio to come back within the limits or it's of no use.

Psychologically, it won't be easy to stick to these rules. Without a doubt, following these rules will reduce your gains during the hot periods of the markets, the same as staying within the speed limit takes the fun out of driving a fast car on an open road. However, the purpose is the same - when there's a crash, there will be a lot less damage.

When there's trouble in the markets, following these rules will ensure that you lose less and your overall gains are actually higher.