Consider two extreme examples of portfolios. One portfolio consists of a single stock. Another holds every stock in the market. The single-stock could fetch any return whatsoever depending on whether it's a multi-bagger, a loser, or somewhere in-between. The second portfolio by definition will get an average market return (this could be a weighted or unweighted average depending on the exact holdings).
Let's assume you hold a big loser in the single-stock portfolio. Now add another stock that is a big gainer. Your returns come closer to the market average because the loss and the gain cancel out to an extent. So far, this is easy to understand. The instant you add a third stock the mathematics becomes complicated. But as you add more stocks, the return will in general, tend to smoothen out.
This “thought experiment” leads us to the concept of risk diversification, which in turn, underlies the concept of portfolio construction. By managing to choose an optimum number of stocks with care and attention, you can lower the chance of a negative return. For example, in a bear market you may still produce a positive return by picking stocks that are negatively correlated with general market direction. And, you can ensure that the company-specific risks are cancelled out.
When we speak of business risk, it can be divided into three broad categories. There are company-specific risks (management, location, etc). There are industry-specific risks (price of raw materials and so on) and economy-specific risk (interest rate risks, currency risks, policy).
Economy-specific risks are common to every business in a given country (or region in the case of Europe). However a currency fluctuation will affect importers and exporters in different ways.
Industry-specific risks also affect different sectors differently. For example, high steel prices are good for Tata Steel but bad for Tata Motors. And, of course, company-specific risks are different for every company. By and large, companies in the same industry will see share-prices move in the same direction though there will be leaders and laggards due to company-specific risks.
Mutual fund portfolios are benchmarked against various market indices. A fund manager is considered successful if he consistently beats the benchmark index. The really great fund managers might give positive returns even when their benchmark is giving negative returns. Most individual investors are far more haphazard in portfolio construction. They buy stocks randomly and they don't consciously construct portfolios to try and diversify risks. What's more, they rarely take the trouble to benchmark their returns versus any index. Even when they do, the index is randomly chosen and often irrelevant.
Unfortunately, most of the public attention is centered on the Sensex and Nifty - these indices are composed entirely of giant market caps. In fundamental terms, each constituent is by definition, a market leader. These scrips are all available in the derivatives segment and therefore exceedingly liquid and possess low delivery ratios. There are no circuit-breakers on these stocks unlike with smaller counters.
The behaviour of giant caps is therefore quite different from the smaller stocks that individual investors tend to concentrate on. There is frequently little correlation between the moves of the Nifty and of midcaps or small caps. Since most retail investors only look at the Nifty or Sensex, they may not even be aware of the most relevant benchmark.
Of course, every stock in a given market has a tendency to move in the same direction due to economy-specific risks. But there are often periods when small or midcap stocks perform very differently from large-caps. An individual investor who is aware of these factors and benchmarking his portfolio correctly has a much better sense of the market and his actual performance. During the past two years (since August 1,2005 actually), if you track the Nifty, the CNX Midcaps200 and the BSE Small caps, the differences become obvious. The Nifty has returned 116 per cent over this period, while the Midcaps have returned 100 per cent and the Small caps 85 per cent. But the performance has also differed from quarter to quarter and even day-to-day. In terms of daily volatility, the Nifty has averaged close to 2 per cent while the Small caps have average daily volatility of 1.8 per cent and the Midcaps have a daily volatility of 1.65 per cent.
An individual investor who buys mostly small and midcap stocks would do well to remember all this and to benchmark his portfolio to the appropriate index.
This article was originally published on November 13, 2007.
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