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Handling Portfolio Size

July 11, 2009

Off late, I had been running quite a whole lot of searches on literature which handles portfolio heat, or optimal portfolio size.

The focus from which I am talking, searching or trying to incorporate is more important for traders and less for the retail “long term view” investors. So that we are all dancing to the same tune, allow me to actually make it sure I state my ideas clearly. For the context of this article, trader is one who usually, but not always makes use of leverage, has a distinct swing trading mental setup and is aggressive in protecting his capital. He is reasonably risk-hardy, yet agressively(well) manages his money. In other words small time traders or  hedge fund managers fall into this list.

Usually, such a trader will hold multiple positions in multiple markets often across geography and flavours. Often heavy positions. The point is, how big a portfolio size he should carry, to ensure that any drastic price shock doesnt wipe him out.

How much? As a function of capital? Or as a function of risk size?

I have been consistently, suggesting my father to cut his losses, and even cut his overall exposure.He had at one time  (hold your breath) 60-70 scrips in his portfolio. And true to everything, he ran himself into a wall, when the equity markets crashed in 2008. Had he been, an independent trader, he would have been bankrupt perhaps. {He is a Chief Engineer in an oil PSU of India}.

He did a few things wrong.  And this is not to take any glory out of him, because what he has done, is commendable how much ever I brain fart around here. Even, I have done many things worse than what he has done, although much higher sophistication was expected of me. But thats another story.

My suggestion for any medium term retail investor{but claims he is a long term investor 😀 } now should be:

  • Maintain a total portfolio size of maximum 12 scrips.
  • Allocate the cash levels across those scrips as per your money mgmt rule.
  • Keep maximum 2-3 scrips in each sector, and preferably one with low mutual correlation {Auto, Banking, Fertilizers & Chemicals, IT, Power,Petroleum can be one sub set}
  • Cut your losses and run.
  • Keep your profits running and don’t book your investing amount.*
  • Once one of the slots empties you can have go for another one.

This might be something for the medium term “investors”, who follow CNBC and buy scrips. Very thumb rule type of general rules and unfortunately I couldnt test the main crux of this article,the first point i.e reducing and keeping the size to 12 scrips.

My logic is simple, if I assume, you have 100,000 bucks, then you will be allocating around 9000 for each scrip, even if I am to assume the retail investor is having an equal unit money management style. This definitely improves the situation if the person goes for better and sophisticated money management style like, equal risk or even equal volatility, Kelly’s Ratio[?]. But why 12? Simple.Can the said person liquidate his entire portfolio within half an hour? 15 minutes? If yes, great.

Secondly, if he wants to run a hedge, by calculating the sum of net beta vis a vis the index and short an equal amount of index futures or buy equal amount of index ATM puts, then will he be able to do it? The amount of puts he has to buy, gets unwieldy if he runs into anything above 20 scrips.

Thirdly, its better to manage those 12 scrips absolutely well,rather than follow sixty of them, without managing them at all.

Running into traders, who use leverage, I would suggest not risking anything more than 14-16 ATRs risk. Again, why? I dont have a way to support it. I can’t really suggest why 20 ATR is worse off than 14-16 ATR risk. But atleast, something is worth following, however “quack-ish” it is,rather than not maintaining any level at all and taking on oneself unwanted risk.The logic is, is there any better answer?( given that I don’t have a way to test it.**)

* This is often a very defensive ploy used by some of the people I have seen, who look for the first opportunity to breakeven. This mentality is not good, if one wants to maximise his worth. Sometimes, even traders are guilty of this, by adjusting the stop to just above the buy price,once the price moves 10-15 points.Even worse is, selling part of the holdings to bring the investing back home.As is often the case, humans are very bad speculating agents, and someone has to pay. If not the psychology, then it will be the turn of portfolio
**I have explored both Amibroker as well as WealthLabs but both lack this feature, of simulating a portfolio and its heat. At the time of writing I am still at a loss of how to mathematically or otherwise simulate it. Any insights into this is more than welcome

2 Comments leave one →
  1. Milind permalink
    July 20, 2009 5:20 pm

    Very Helpful article. Some of the terms like ATR etc are not known but overall message is clear. Thanks for posting such nice article.

    Sometimes, even 12 scripts can be reduced to 11 to make 9.99% in each script. There might be little imbalance if there is sudden rise is share price due to some triggers ( Like RIL few days back or Infy/TCS currently).

    Do you consider MF as one script or that will be different asset allocation. I am kind of investor as you described you father but with much younger age profile. I never tried to understand FO or Derivatives and happy to buy and hold for long term.

  2. Soham Das permalink*
    July 20, 2009 8:36 pm

    Thanks Milind,
    To be frank, managing portfolio heat is a much advanced concept with its roots in very hard core mathematics[Efficient Frontier and Markowitz portfolio e.g]. This is a mere thumb rule type of a guideline, borne a lot out of experience rather than mathematical proofs.

    I would suggest, to investors to take care of risk by simple money management methods [I can see myself kicking for letting such a valuable thing public :D, though its not a secret]. Even Kelly’s Ratio will do better than going with a “Quickgun Murugan” approach.

    Do I consider MF as one scrip?
    Short Answer: No

    Long Answer: To be frank, I consider MF as a money swindling setup for gullible investors. Most of the money managers keep harping about their stock picking potential only to come home with a bloody nose and a falling performance. Many of them, returned negative returns even in a raging bull run like 2k3-2k7. It just doesnt make any sense.Hence I would be happy to maintain a huge distance from MFs.

    Suggestion: Would suggest you strongly for ETFs. You can treat them as a single position.

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