plan equity portfolio

ASSET ALLOCATION DEMYSTIFIED How To Plan Your Equity Portfolio

~ 1 ~

Preface

‘Equities’ is just an 8 letter word. At the same time, the amount of theories, concepts and

scenarios associated with it are many. So, investors have a number of queries related to

investing in equities. The top most being, “How and where do I allocate my money in

equities so as to get the best results?” Usually, brokers are of little help, spouting some well

rehearsed statements involving jargon and heavy words. Well meaning friends too, do not

always end up giving a crystal clear picture.

This guide is an effort to highlight the various factors influencing asset allocation in equities.

In this asset allocation guide, we will have a look at how best to allocate your equity

investments so as to achieve optimum returns from them.

We are certain that you will find this guide useful. We encourage you to share your thoughts

and feedback on this guide on asset allocation in equities.

Warm regards

Team Equitymaster

Disclaimer Equitymaster Agora Research Private Ltd (Equitymaster) is the owner of the copyright in this Report. The readers are requested to note that this Report is only meant for personal use of the Subscribers of Equitymaster. Any act of copying, reproducing or distributing this Report whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement. This Report is for information purposes and is not providing any professional/investment advice through it and Equitymaster disclaims warranty of any kind, whether express or implied, as to any matter/content contained in this Report, including without limitation the implied warranties of merchantability and fitness for a particular purpose. Information contained in this Report is believed to be reliable but Equitymaster does not warrant its completeness or accuracy. Equitymaster will not be responsible for any loss or liability incurred by the user as a consequence of his taking any investment decisions based on the contents of this Report. Use of this Report is at the user’s own risk. The user must make his own investment decisions based on his specific investment objective and financial position and using such independent advisors as he believes necessary.

mailto:[email protected]



~ 2 ~

Contents

Importance of Asset Allocation ……………………..………………………………..

Why should one opt for asset allocation in equities

3

Understanding Equities ………………………………………………………………

It’s important to the difference between large caps, mid caps and small caps

6

Setting the Foundation for Equity Allocation ……………………………………

Planning your portfolio is now easy!

10


~ 3 ~

Importance of Asset Allocation In the past few years, the stock market has been on a roller coaster ride. Investors have seen

the Sensex reach dizzying heights and then crash with equally dizzying speed. One moment

the surge was the toast of the town. At the very next moment as the Sensex crashed, so did

people’s dreams; and investors were in a state of collective mourning.

Even as the markets today look promising, many investors are still confused. “How and

where do I invest my money,” is the question on everyone’s mind.

While investors know that equities or stocks should form a key component of their

investments, they still do not know how they should go about deciding which companies to

invest in. So, they usually tend to rely on ‘tips’ or on their broker’s or friends’ advice. Then

when an unforeseen situation like the Stock Market crash is witnessed, that is when the

proverbial cookie crumbles.

In order to safeguard one’s investment, it is essential to follow the principle of “asset

allocation” while investing in equities.

So what exactly do we mean by ‘asset allocation’ with regards to a stock

portfolio?

Simply put, asset allocation in equities is just a practical extension of the age-old adage - “Do

not put all your eggs in one basket.” It advocates the need to have a stock portfolio where

your investments are distributed over not only different companies and sectors, but also cover

different types of equity groups such as small caps, large caps and mid caps. The actual

allocation should be a function of your investment objective and also your appetite for risk.

When you smartly allocate your ‘equity money’, the risks you take get distributed.

Suppose, for instance, there is a drought and as a result of which consumer demand in the

country is expected to suffer a setback. Now, companies which are focused on selling their

goods and services to the domestic market are likely to take a hit as their near term prospects

no longer look great.

But on the other hand, a company that is selling software services in the global market will

be relatively isolated from these developments. So, having both such companies in a

portfolio has the impact of reducing the volatility in returns over time.


~ 4 ~

Thus having stocks across sectors is a step towards investing wisely. Holding stocks of

companies with different market capitalization (like small caps, mid caps and large caps) is a

step further in the same direction.

A small cap company like NIIT, with a market cap of Rs 10 billion, may promise greater rate

of returns compared to say a large cap company like Infosys which has a market cap of Rs

1,400 billion. However, the security of having a blue chip company like Infosys in your

portfolio cannot be matched by small caps.

This is of course a very simplistic example, and the following articles will discuss the

pros and cons of companies with different market caps even further, but the core idea is

to have a mix of companies in a portfolio.

Let’s take another very well known example: During the late 1990s everyone was talking

about and investing in what they called “Tech stocks” as technology was perceived to be a

booming sector. Everyone wanted to position their portfolios and capitalize on what was then

called the ‘new economy’. And we know what happened soon after… tech stocks crashed. In

fact hundreds of these tech wonders actually disappeared (mostly the smaller companies)

leaving a big hole in investors’ portfolios. A smart investor, who had a well diversified

portfolio, though impacted, far outperformed ‘tech’ leveraged investors over the years that

followed.

And at the end of the day, that’s what matters the most - what you earn from your

stock portfolio over the long-term. After all stocks are instruments that are best suited

for generating long term wealth!

Why should it be done?

We need the returns on our investment for different reasons. Some invest in equities to secure

their life after retirement. For others, equities are meant to be used for their child’s marriage

or education. For some others it may just mean funds for planning a world tour two years

down the line while for some it may be a combination of all these goals.

As our needs differ, so does the time period needed to fulfill them. While planning for a

world tour may be viewed as a short-term (2-5 yrs) objective, investments done for a child’s

education may be done keeping in mind a time period of 5 - 15 years. So based on the

duration for which you require to keep your money invested in, you need to accordingly

allocate your ‘equity money’.


~ 5 ~

How do you draw the ideal asset allocation plan?

Each individual is different so an asset allocation plan will differ from person to person based

on his or her personality traits, age, risk taking capacity and the ultimate investment objective

in mind. One cannot take a ‘one size fits all’ approach.

Building a stock portfolio is a complex activity. In this guide we will focus on one very key

aspect - how to allocate your portfolio between large cap, mid cap and small cap stocks. The

following articles are aimed at giving you a deeper understanding of the various parameters

influencing asset allocation in order to benefit the most from your investments.


~ 6 ~

Understanding Equities:

Differences between Large caps, Mid caps and

Small caps

When understanding how to allocate funds for investing in equities, it is important to

understand both your expectation of return (a function of your financial goals) and also your

risk appetite. Once you are clear on these, it will be a lot easier for you to allocate money

between the various categories of stocks.

In the first article, we understood the basic fact that investing is essential for achieving your

financial goals. Now, let us step forward and understand the three categories one has to pick

from for one’s portfolio.

Understanding ‘Market capitalisation’

There are three main classifications when it comes to stocks -

1. Large Cap stocks;

2. Mid Cap stocks; and

3. Small Cap stocks.

Here, the term ‘cap’ simply refers to the ‘market capitalisation’ of the stock.

And what is market capitalisation?

It is the value of the stock that you arrive at by multiplying the stock price by the company’s

outstanding number of equity shares.

Market Capitalisation = Current Stock Price x Number of Shares outstanding


~ 7 ~

For a better understanding, let us see an example:

Company XYZ has 10,000,000 shares outstanding and its current share price is Rs 8. Based

on the above formula, we can calculate that Company XYZ's market capitalisation is Rs 80

million, or 10,000,000 shares x Rs 8 per share.

Large cap stocks

As we mentioned above, the first category based on market capitalisation is that of ‘large cap

stocks’.

One can look at the BSE-Sensex or BSE-100 Index as a reference point for large cap

stocks. Market capitalisation for stocks in the BSE-100 Index, for instance, ranges from

Rs 200 bn to Rs 3,500 bn.

These are stocks of usually large and well-established companies that have a strong market

presence and are generally considered as safe investments. One important fact about large

caps is that information regarding these companies is readily available in newspapers and

magazines. Most of the large cap companies have good disclosures and therefore there is no

dearth of information for an investor looking into them.

Large companies such as Infosys, TCS, and Wipro are classified as large cap stocks. These

companies have been around in the industry long enough and have firmly established

themselves as leading players. Their stocks are publicly traded and have large market

capitalisations.

Mid cap stocks

Mid caps lie between large cap stocks and small cap stocks. Mid cap stocks are those that

generally have a market capitalisation within the range of Rs 50 bn and Rs 200 bn.

These represent mid-sized companies that are relatively more risky than large cap as

investment options yet, they are not considered as risky as small cap companies. They rank

between the two extremes on all the important parameters like size, revenues, employee and

client base.

When one invests in mid caps for the long term, he may be investing in companies that could

become tomorrow’s runaway success stories. Generally speaking, mid cap stocks as an

investment can bring you higher returns in 3 to 5 years as opposed to their big brother large

cap stocks that can bring you moderate (yet safer) returns during this timeframe.


~ 8 ~

Small cap stocks

Lying at the lowest end of market capitalisation, Small cap stocks are generally viewed under

the misconception of being hazardous or ‘quick rich’ stocks. However, both these labels are

untrue.

Small cap companies have smaller revenue and client bases, and usually include the start-ups

or companies in the early stage of development. Small cap stocks are potentially big gainers

as they are yet to be discovered within the sector and can show growth potential in large

numbers once unfurled in the market. However, as these enterprises are small ventures, these

should be researched properly. This is considering that a lot of small companies do not have

the financial strength to survive bad times and some of them might be mismanaged

businesses run by greedy promoters. Hence it is essential, especially in the case of small caps

investments that one does a thorough research regarding the promoters’ credentials,

management strength and track record, and long and short term growth plans of the company

before investing.

Small caps are often stated to be a platform to make big returns in a short span of time.

However, we would state that small caps can prove to be a very wise ‘long term’ investments

especially if the chosen companies are good businesses and are well-managed.

Have a look at the table below to get a better idea about the return potential of small cap

stocks over a 10 year period.

Small cap wonders

Change in share prices over the past 10 years

Company 15-Dec-99 15-Dec-09 Change

Aban Offshore Ltd. 6.7 1,191.2 17,705%

Era Infra Engg. Ltd. 1.2 197.0 16,181%

Shriram Transport Finance Co. Ltd. 4.5 451.3 9,929%

Kalpataru Power Transmission Ltd. 20.0 1,020.2 5,001%

Jubilant Organosys Ltd. 6.6 332.0 4,907%

Amtek Auto Ltd. 3.8 185.6 4,783%

Praj Industries Ltd. 1.9 91.0 4,687%

Pantaloon Retail (India) Ltd. 7.4 345.1 4,544%

Havells India Ltd. 9.8 430.0 4,306%

Motherson Sumi Systems Ltd. 3.0 125.1 4,125%

Source: CMIE Prowess


~ 9 ~

Now here’s a table that clearly shows the differentiation between the three category of stocks

we spoke of above - large caps, mid caps, and small caps.

Key parameters for IT stocks across market caps

Important parameters Large Cap Mid cap Small Cap

Infosys Mindtree NIIT Technologies

Current Market cap (in Rs billion) 1,400 26 10

Revenues*(in Rs billion) 217 12 10

Net profits * (in Rs billion) 60 1 1

Number of employees* 104,850 7,866 4,238

Number of clients* 579 261 130

* For year ended March 2009

Conclusion

As seen from the above discussion, an investor has three options to choose from as far as

allocating money to stocks is concerned. And the allocation is dependent entirely on an

investor’s risk appetite. All these categories consist of some really good long term investment

opportunities. As such, investors must decide the allocation based on the opportunity’s merit

and not just whether it is a large cap, mid cap, or small cap.

But purely as a matter of prudence and safety, investors looking to build a portfolio from a 10

to 15 years perspective can have a 60-70% allocation to large caps and 10-15% each to mid

and small caps. Treat this allocation as just a guideline and, we repeat, allocate your equity

portion using your understanding of different kinds of companies across different levels of

market capitalisation.


~ 10 ~

Setting the Foundation for Equity Allocation

Now that you have understood the basics of investing, we can get into the more specific need

of building a portfolio that fits your needs. Along with keeping in mind your risk appetite, it

is firstly important to identify your age factor, earnings, and objectives for creating wealth.

Keeping in mind that we can’t have a ‘one-size-fits-all’ strategy, we have discussed broadly

the different and necessary key assumptions required towards an investor:

Being single

As the old saying goes, what the wise man does in the beginning, fools do in the end. When

you’re young and without a care in the world, life seems perfect. If you haven’t crossed the

30 mark, and are still single, planning for your retirement or even your future seems a distant

thought. But wise are those who start planning from the start!

Life as a singleton is often a lot more carefree and individualistic. You tend not to think of

additional responsibilities such as kids, housing, schooling etc. it’s all about working hard,

partying harder and living it up. But somewhere reality sets in and that’s when you start

preparing to plan for your future.

Asset allocation portfolio for a singleton

Single

<30 years 30-45 years

45-55 years

>55 years

Carefree Building Wealth

Adding To

Wealth

Carefree Retirement

Large cap 70-80% 60-70% 70-80% 80-90%

Mid cap 5-10% 10-15% 10-15% 0-5%

Small cap 5-10% 10-15% 0-5% 0-5%

As a young and single individual, under the age of 30, you would enjoy a carefree lifestyle.

As a single person you would have lesser earnings due to a single source of income, and

would most definitely have more expenses keeping in mind the way most people enjoy a

high profile lifestyle. Then, for a person like you, the best kind of investments would be

those of investing into safer large cap stocks which would ensure a safe return at the end of a

longer tenure.

As you progress through the years and become stable in your career, your income starts to

rise and you can ideally afford to take a slight amount of risk towards wealth creation. It


~ 11 ~

would be advisable at this juncture to invest in mid and small cap stocks as you cross 30

years of age.

Mid and small caps are usually suggested at this juncture as they bring higher returns in a

shorter span of time or even if you invest in small caps for a long period of time they will

bring you higher returns than that of simply investments in large caps.

As your age advances, the inherent urge to take risks reduces. So, as you approach the 45 to

55 age bracket, you would want to take lesser risks, and therefore your concentration shifts

from simply building wealth as you may have done earlier, to adding to your wealth. At such

a stage, the majority of your portfolio (70-80%) should be in large caps. This not only

ensures safety of the original capital invested, but also ensures safer returns on the said

capital.

Once you cross 55, it’s all about looking towards building a safe retirement plan at around

60. This is the time to start increasing allocation to safer stocks - large caps. Allocation to

mid and small caps should reduce, while the same towards large caps should increase to 80-

90% of the total portfolio.

Two’s company

There are those who enjoy their single status in life, and then there are those for whom life is

about having someone to share it with. Sharing joys and sorrows, sharing health and wealth,

it’s all become about being a couple for some.

Asset allocation portfolio for a person who is married and has no kids

Married- No kids

<30 years 30-45 years 45-55 years >55 years

Property Top Priority

Building Wealth

Planning Retirement

Carefree Retirement

Large cap 70-80% 60-70% 70-80% 80-90%

Mid cap 5-10% 10-15% 10-15% 5-10%

Small cap 5-10% 10-15% 0-5% 0-5%


~ 12 ~

There is a famous acronym for working couples in the West - DINK, deciphered as a

‘Double Income No Kids’ family. This concept is also now being adopted within the Indian

culture amongst the youth, who work harder to earn and enjoy spending their wealth between

the husband and wife only.

However despite the ‘double income’, as a married person you would still have more

expenses compared to the earnings as there is a second person to fend for as well. The most

practical approach to investing at this point would be to invest a greater portion of your

equity investments into safer large cap stocks.

Similarly as it is with singletons, once you cross the 30 age mark and your income has risen,

there is a sense of having achieved financial stability. You feel more secure in your financial

growth and hence find it easier to allocate a slightly larger amount (10 to 15%) as opposed to

earlier towards small and mid cap stocks, in order to generate wealth.

Once as a couple you reach the circle of 45 to 55 years of age, you usually start thinking and

planning for your retirement as opposed to creating wealth for purposes such as buying a

house, holidays, jewellery etc. Hereon it would be best to allocate a significant portion of

your funds (70-80%) towards large caps and pare down the investments in small caps.

Once the magical number of 55 years hits you, the main focus remains the retirement plan

you have been building. As a couple without children to support them after retirement, this is

a very important corpus. It would be best to further increase allocation to safer large cap

stocks while reducing allocations to mid and small caps, so as to ensure that you have built a

safe and secure corpus funding for your retirement.

Family matters

There is a famous line - ‘Small family, happy family’, but where exactly is that line drawn

today? Would it end at being a happy couple, or would it end with the proverbial husband–

wife and child scenario? If we were to go by the population of India, it would most definitely

be a family inclusive of kids. Yes, there are the rare exceptions to the norm, but on an

average the idea of a happy family consists of a set of parents with 2 kids.


~ 13 ~

Asset allocation portfolio for a person who is married with two kids

Married-2 kids

<30 years 30-45 years 45-55 years >55 years

Property Top Priority

Planning Children's

Future

Property For

Children Retired/Children On

Own

Large cap 70-80% 50-60% 70-80% 80-90%

Mid cap 5-10% 25-30% 10-15% 0-5%

Small cap 5-10% 5-10% 0-5% 0-5%

Being a married couple is not easy and especially if you are a married couple with 1-2 kids.

Your main priority at the age of 30 or so would be to ensure you provide your family with

housing. A crucial factor at this point would be that even if there are two incomes, the

expenditure would most definitely be more, given the fact that there are more than two

mouths to feed. It would be best for you to allocate a greater portion of your equity

investments into safer large cap stocks.

As you cross the 30 year mark, the main focus would be creating wealth for the future needs

of your children. As kids start growing up the responsibilities that arise along with them need

to be addressed and planned for in advance - such as children’s education, marriage and

property plans too. At this juncture since your earnings have increased and your career has

gained more stability, you are better positioned to take more risks towards portfolio

management. Hence you can invest a slightly large sum (10-30%) towards mid and small cap

stocks.

As you grow in age, so do your kids and so do their needs and demands. Once the 45 age

mark is crossed, your main concern becomes fulfilling the immediate concerns of your kids

lives, such as their growing needs of higher education and perhaps even marriage plans,

within the time span of another 5 years or so. Keeping this time factor in mind it is best to

redirect your equity allocation more towards large caps (70-80%) which will bring you safe

returns, and minimise your sum invested in Small and midcap (5-15%).

Once your children have been educated and are settled with their own lives, you tend to be

concerned with your own plans of creating sufficient wealth for an easy and relaxed

retirement, which will soon be approaching. At this point it is best to switch most of your

allocation into large cap stocks, while reducing investments in small and mid caps stocks.


~ 14 ~

Conclusion

There’s a saying “Boulders we cross, it’s the pebbles that we stumble over”. That is exactly

what happens as we strive hard to build our wealth. We work hard, scrimp, save, make

adjustments and finally save money - for us, our dreams, our children and their dreams.

Somewhere, however, we are so busy trying to survive in our race against time that the

money that we earn so hard is invested quite quickly, without giving it the much needed

thought - ‘are our investments are in tandem with our current and future needs?’ This is

where the mantra of asset allocation comes handy.

Asset allocation ensures that our expectations from our investments, our dreams for our

future and the way we invest money are all in sync with each other.

To know more about how Equitymaster can help you earn extraordinary returns, call us at

1800-209-3786 or Email us at [email protected]. We will be delighted to hear from you!


plan equity portfolio

Documents