The BEST Framework to Create a Diversified Stock Portfolio

Constructing a well-balanced and diversified stock portfolio is an essential strategy for investors seeking long-term success. To ensure optimal returns and reduce risk, it's important to understand the complexities involving diversifying your investments. In this article, we explore what a portfolio is and how you can diversify your investment portfolio with the best framework

What is a Portfolio?

A portfolio can be defined as a collection or basket of securities. It’s vital we invest in multiple assets from different asset classes and sectors. A portfolio of assets can help you build wealth over the long term. We target a portfolio return of 15-25% CAGR over a long investment horizon, which is more than enough to achieve financial freedom.

Why Should You Diversify?

Apart from not staying invested for the long term, another common mistake that beginners make while starting long-term investing is that they invest in just 2-3 stocks. Beginners follow tips from social media channels that claim multi-bagger returns if they invest in these 2-3 stocks. But what would happen if any 2 out of these 3 stocks start performing poorly? You are going to lose most of your money. Therefore, the first and most important objective of a portfolio is to diversify and provide downside protection.

Portfolio: Not Necessarily Downside Protection

Apart from downside protection, a portfolio can reduce risk by combining securities whose returns do not correlate. Sometimes, an asset class or a sector might go down in value while another sector or asset class goes up in value. Combining assets that have a negative correlation helps to offset each other. 

The Modern Portfolio Theory (MPT) states that investors should not only hold portfolios but should focus on how individual securities in the portfolios are related to one another. Although this theory has many limitations, the principles of this concept continue to be the foundation of knowledge for portfolio managers.

You Only Live Once (YOLO)?

We always preach investing in a portfolio of stocks rather than just 3-4 stocks that could be the next multibagger. But should you do it? It is absolutely possible to invest in just one stock and reap 10x returns. However, we would not recommend this for a consistent long-term wealth-building strategy.

By investing in just 3-4 stocks, you are potentially harming your way to financial freedom. What would happen if your strategy fails? You lose your money, your financial freedom, your mental peace, and a lot more. But by choosing the safer path and investing in a diversified portfolio, you can achieve your retirement goals and financial freedom. 

The win-win solution to this problem is to consistently invest the amount you need to achieve financial freedom by retirement, and any sum of money over that amount, you can use for doing YOLO investments and potentially become the next Rakesh Jhunjhunwala. This way, you can make concentrated investments into potentially multibagger stocks without a trade-off on your financial freedom.

Asset Class Diversification

An asset class is a group of assets or investments that have similar characteristics. There are two types of investments: traditional and alternative. Traditional investments consist of publicly traded investments in stocks, bonds, and cash. Alternative investments are broadly classified into: private capital, real assets, and hedge funds. The alternative investment asset that we will be investing in is gold, which falls under real assets.

1. Equity will contribute to growth - High ROI but higher risk

You can directly invest in equity directly or indirectly by investing in equity mutual funds.

2. Debt & Gold will contribute to safety - Low ROI but lower risk

• You can invest in debt mutual funds or liquid bees ETF
• You can gain exposure to gold by investing in gold ETFs, digital gold, and sovereign gold bonds (SGBs).

3. The minimum recommended equity-debt allocation is 80-20. As your age increases, you can invest more into debt than equity.

Why invest in debt and gold?

Debt instruments give fixed returns as compared to equity. Therefore, even when the market is in bad shape, debt instruments can give you returns. Gold belongs to real assets under alternative investments. Traditional investments and alternative investments have a negative correlation and thus offset the negative returns that the equity in your portfolio might make.

Market Cap Diversification

Market capitalization refers to the total value of all of the company’s issued shares. It’s the valuation of a company. 

Market Cap = Current Share Price x Total Outstanding Shares. 

Market cap diversification refers to the diversification of equity based on the market capitalization of stocks. The three different market cap divisions are:

1. Large-cap - Stocks that have a market cap of more than ₹20,000 crores. The top 100 companies with the highest market capitalization fall under large-cap. These are also known as blue chip stocks.

2. Mid-cap - Stocks that have a market cap of fewer than ₹20,000 crores but higher than ₹5,000 crores.

3. Small-cap and micro-cap - Stocks that have a market cap of fewer than ₹5,000 crores. 

Moderately Aggressive Portfolio

• Large-cap - 50%
• Midcap - 30%
• Smallcap - 10% (first 250 small-caps)
• Microcap or Bluechips - 10%

You can invest the final 10% of your portfolio into small caps or blue chips depending on your risk appetite.

As a thumb rule, your portfolio should comprise 50-70% large-cap stocks, 20-40% midcap stocks, and 10-20% small-cap stocks.

Sectoral Diversification

A sector refers to a group of companies from the same industry. Given below are  the major sectors in the Indian stock market:

• Automobile
• Bank
• Consumer durables
• Financial services
• FMCG
• Health
• IT
• Media
• Metal
• Oil and Gas
• Pharma
• Realty

Another common mistake beginner investors make is investing in just 1-2 sectors, which is equally disastrous as investing in 2 or 3 stocks. If the industry or sector starts performing poorly, the whole portfolio might go down.

We should give exposure to at least 4-5 sectors and generally align with the market when we invest for the long term. But what does aligning with the market mean? It means that we should take NIFTY’s sectoral diversification as a reference:

We can follow a similar sectoral diversification while creating a portfolio.

Rules to Follow

1. Do not invest more than 20% of your capital into a single stock.

2. Do not invest more than 40% of your capital into a single industry.

3. Do not invest more than 15% of capital in small caps.

4. Always diversify.

5. Review your exposure frequently.

6. Don’t fall under peer pressure.

7. Always keep some cash available to invest if the market falls. Remember that every fall is an opportunity to invest more.

Model Portfolio

A model portfolio has been created by us for reference in collaboration with industry experts. This portfolio is well diversified and contains 19 stocks across 10 sectors. Even if a few of the stocks start doing badly, the overall portfolio won’t be affected much.

How to Create a Diversified Portfolio - The Flow

Let’s summarize and structure what we learned: 

1. Find potential quality stocks to invest in 

2. Perform fundamental analysis

• Read and analyze annual reports
• Read and analyze financial statements
• Perform ratio analysis
• Find valuation
• Decide on value or growth investment strategy

3. Make a list of stocks that you find investment-worthy and classify them based on market cap and sector.

4. Decide on capital allocation to each sector and market cap.

5. Compile a portfolio of 15-20 stocks

6. Start investing!

Throughout this article, we have learned how to create a well-diversified portfolio for your long-term investment journey! Happy Investing!