Not sure about how much you should allocate to a stock in your portfolio? Here's some help to determine the weights in your portfolio.
03-Aug-2022 •Karthik Anand Vijay
In the previous story, we talked about the perils of investing in government-owned companies.
Now we will discuss how to gather the chosen companies to form a portfolio. Here, the first thing you have to consider is how to assign weights. It is the percentage a company holds in your portfolio.
How to assign weights?
Start by analysing the future growth prospects of each company and the probability of that materialising. The company with the brightest prospect and the highest probability should be assigned the highest weight. But also consider its management's ability, corporate governance and other important factors.
Interplay with the number of companies you own
Ideally, you should assign weights by considering the factors mentioned above. However, if you plan to own a few companies and place large bets on them, then you can very well assign equal weights to each company.
In case you hold many companies, you may opt for a more subjective approach to assigning weights by considering the factors mentioned above. The reason is that the growth prospects of each company wouldn't be in the same ballpark, as some sectors are expected to perform better than others. Analyse your companies and increase the weightage of companies in such sectors. Also, giving minuscule weights (like less than 1 per cent) to companies will not improve your overall return.
Other factors to consider
As assigning weights requires a fair amount of research, you need to be correct in your analysis. Since mistakes are a given and if you find this to be too tenuous, then you can just assign equal weights.
The size of the company is also an important factor to consider. A high-quality large company with moderate growth will have a different weight as compared to a high-quality small company with high and durable growth. Logic dictates that the latter should be assigned a higher weight than the former.
However, you may assume that given its size, the larger company is safer than the smaller one. Unless there is a credible reason, you shouldn't accept that assumption. Your understanding of the companies will determine whether you can weigh logically.
Another thing to think about is how you deal with volatility. Volatility can play with your head. If you have done the job correctly, then you shouldn't worry about the impact of volatility on your portfolio. In fact, such moments should be used to make strategic calls. Use it to increase or decrease the weights based on your analysis.
Lastly, do take into account your experience as an investor. In bull runs, it's tempting to go overboard on smaller companies. In bear markets, smaller companies suddenly appear to be dispensable. Often narratives are crafted to justify the stock move. But these narratives change as market conditions change. Thus, for most investors, it's better to keep a higher allocation to large/mid caps as compared to smaller companies and spread the corpus across sectors.
There is no perfect or correct method of getting this right. You have to be knowledgeable about your companies and keep track of them. The weightage depends on your understanding of the company and your comfort level.
Also in the series:
How many stocks should you own?
Which investing style is the best?
What is the right market-cap mix?
How should you research stocks?
What sort of businesses to prefer?
Should you invest in PSUs?