How to Build a Profitable Portfolio

Are you looking for a way to capitalize on the immense wealth-generation opportunity offered by the stock market?

Of course you are. Otherwise you wont be reading this :-).

So let me cut the chase. The secret to being filthy rich lies in building a profitable portfolio of stocks.

And that's what this part of our Stock Market 101 series is about i.e. building profitable portfolio.

Let me begin the discussion by telling what I mean when I say profitable portfolio.

Have a look at the various categories most portfolios fall into:

1. Portfolio that goes to 0

2. Portfolio that is in loss

3. Portfolio that earns more than your saving bank account (4%)

4. Portfolio that earns more than your FD (6%)

5. Portfolio that earns more than Nifty/Sensex returns (12%)

For me, any portfolio that earns in excess of 12% year on year is a profitable portfolio.

Having clarified on what a profitable portfolio means, let's now discuss the steps to build one.

Spare Capital

The only necessary and sufficient condition to start building a portfolio is availability of spare capital.

How you choose to define the word "spare" can significantly impact the profitability of your investment portfolio. If you approach this decision with care and thoughtfulness, you can surely increase your chances of achieving a return of greater than 12%.

Here are some key characteristics of an ideal spare capital to begin with. It should be:

1. Fully Disposable: Spare capital should be fully disposable, meaning that it is not required for your day-to-day expenses or emergencies. You should only invest money that you can afford to lose, as there is always a risk of total or partial loss when investing in the stock market.

2. Non-essential: Spare capital should be non-essential, meaning that it is not required for any future expenses or goals. It should be money that you can afford to invest for the long-term, without needing to access it in the near future.

3. Sufficient: Spare capital should be sufficient to allow for investment in a diversified portfolio of stocks. This means having enough money available to invest in a range of stocks across different sectors to spread your risk and take advantage of different growth opportunities.

4. Separate: Spare capital should be kept separate from your other savings and investments. This can help you to maintain a clear understanding of your investment strategy and goals, and avoid mixing your spare capital with other funds that may be needed for other purposes.

To cut long story short:

Spare capital is the the capital which you have, but you must not treat it as yours. 

If you think carefully, this detachment gives you super power in the arena of stock market.

How?

The moment you consider the capital as not yours:

1. You get the power to commit it for long term

2. You get immune to short term volatility that forces most of the people to sell at the most wrong time

Hear this:

Stock market eventually and handsomely rewards anyone and everyone who stands long enough in the queue.

And what helps you stand long enough in the queue is the Spare Capital.

But what if I belong to नंगा नहायेगा क्या और निचोड़ेगा क्या category? What if I don't have spare capital?

If this is what you are thinking, then here is the secret to build spare capital without sacrificing much. 

From now on, think that you earn only 90% of your actual earning. The remaining 10% every month goes to your spare capital account. Although 1, 2 years may sound like eternity now, by the end of it, you will surely have the desired spare capital. Believe me, 2 years passes in a blink of an eye.

Once the desired spare capital is available, building portfolio basically involves three key activities:

Buying, Holding and Selling

Let me elaborate a bit on the three activities:

1. Buying what will perform well 

2. Holding what is performing well

3. Selling what is not performing well and reallocating to stocks from 1 or 2 above

In this discussion I will focus on activity 1. Activity 2 and 3 will be dealt in next part of the series.

Why?

They say, attention span is a very costly commodity now a day.

So let me keep it short and sweet for you. You can always read other parts if it makes sense.

1. Buying what will perform well

As a beginner in the stock market, you may feel overwhelmed by the prospect of building your own profitable portfolio. However, by answering three key sub queries related to your buying decision, you can approach this task with more confidence and clarity:

1. What should I buy? When choosing stocks to invest in, it's important to consider factors such as the company's financial performance, industry trends, and management team. Conducting thorough research and analysis can help you identify companies with strong growth potential and a solid track record.

2. When should I buy? Timing is also a crucial aspect of stock investing. While it's impossible to predict the future performance of a stock with certainty, paying attention to market trends and stage can help you make informed decisions about when to buy.

3. How much should I buy? Determining the appropriate amount to invest in a particular stock depends on a variety of factors, such as your overall investment goals, risk tolerance, and financial situation. To add salt to the wound, it's really confusing to quantify these parameters.

By the way, which of the 1,2,3 above you think is easiest to execute.

The right order with respect to ease of execution is 3, 2, 1.

I will tell you why.

How much should I buy?

Remember, we are aiming to build a profitable portfolio.

Now refer back to the top of the article where we listed various categories that most portfolios fall into.

I hope you will agree that, any portfolio can be profitable only if it does not fall into category 1 i.e. it does not go to zero. 

So the very first challenge here is to fool proof your portfolio from going to zero or risk of ruin?

That's half battle won.

There is a rule based approach to address this challenge. It's called diversification.

Diversification helps avoid the risk of ruin by spreading your investment across multiple stocks or asset classes, reducing the impact of any single investment's performance on your overall portfolio. This helps mitigate the risk of significant losses and protects your portfolio from being completely wiped out due to the under performance of one particular investment.

Here is how you do it in 3 simple steps:

When will the above portfolio go to 0? When all the 10 stocks go to 0 simultaneously. Right?

Now compare this with a 0 diversification strategy wherein you used all you spare capital to buy just one stock.

When will your portfolio go to 0 in this case? When only one stock that you hold goes to 0. Right?

Probability of which of the following 2 is higher?

Hope now you understand why diversification helps in avoiding risk of ruin without putting any extra effort. 

Now 10 is not a magic number here. You should use it as a guideline to start on diversification task. With time you will automatically figure out what's the best number for you.

In summary, the key assumption behind diversification is:

Not all the stocks will go to zero simultaneously.

Trust me, this assumption has saved many lives in stock market.

Interestingly, diversification automatically answers the question or dilemma number 3 i.e. How much of a particular stock to buy. 

The answer is, as much as your chunk size allows. So for the example we discussed above, you can buy as many stocks as you can buy with INR 10,000.

If you were paying attention then you must have noticed that what rendered diversification look easy is adhering to a rule based approach. We can use similar rule based approach to answer dilemma number 2, which is:

When should I buy?

Everyone desires to buy at the bottom and sell at the top. I am sure you also want to do the same. 

This skill is called timing the market. 

Do you know who successfully times the market every single time?

1. God

2. Liar

3. I

I am sure you have not met God.

I am equally sure, you can now spot a liar in the stock market ;-). 

What about the option 3?

Believe me, I know How to successfully time the market. And I am not a liar.

And definitely not a God either.

Then how do I successfully time the market?

I do that by waiting. More precisely, by waiting for market to fall. 

That's the reason I said this step is tougher than the previous one.

Believe me, just waiting and doing nothing is really tough.

Anyways, here is the rule based approach I follow to successfully time the market. I wait for the market to fall and:

1. If the market falls by 10%, I buy.

2. If the market falls by another 10%, I buy.

3. If the market falls by another 10%, I buy.

Market ultimately goes up after falling. So after some days or months, when the market has risen by 10%, 20% or 30%, I can claim that I successfully timed the market.

Trust me, I have done this multiple times and you can do it too.

Why?

Hear this:

With every successive fall in the market, the profit potential diminishes for sellers as the price has a lower bound of 0. Beyond a point, there is going to be no marginal gain for the sellers and that's where the reversal occurs in bear market.

So I just trust the cycle and act accordingly.

Let me reiterate though. Waiting and doing nothing will be tough. Trust me, most fail here. 

Again 10% is not a magic number here. Use it as a guideline figure to start and you can adjust as per your comfort and patience level in future.

In summary:

Keep it simple. No one knows anything. Trust yourself and use a rule based system to time the market.

Hope this answers the dilemma when to buy. 

Now we are left with the final sub query which is:

What should I buy?

Buying stocks can be a challenging activity for beginners for two key reasons:

1. The list of available stocks is huge: There are thousands of publicly traded companies, and it can be overwhelming for beginners to know where to start. Want to know how many?

2. Stock prices can be volatile: Stock prices can fluctuate rapidly based on various factors, such as company news, economic indicators, and global events. This volatility can be unsettling for beginners, who may not be used to seeing their investments go up and down so frequently.

Hope now you understand why I tagged this as the toughest of the three buying sub queries.

Remember what helped us in answering the previous questions? 

Yes you are right - rule based approach. We will use it again.

Hear this:

At the core, buying a share means you are buying a share in the company's profitability.

Which in turn means, your gains from owning a share is dependent on the company's earnings.

The more the company earns, the greater the share price appreciation plus more dividends you get.

So, in the backdrop of Earnings being the keyword and stock prices being slave of earnings, let's lay down a rule based approach to decide on what to buy?

Here is a proposition from my side:

I use this personally as my watch list and more often than not, stocks go to my portfolio from this list. By the way, you can do all the above here. 

Great, now you have the Version 1 of your stock portfolio.

I am sure you can design better approach than this once you spend some time in the market. However, as a beginner, you should start somewhere and this framework provides you with a good starting point.

Ok, I have Version 1 of my portfolio. Now what?

We will cover this in the next part of the series.

But before I take your leave, I would like you to hold on for a moment and appreciate the beauty of the following statement.

Any and every portfolio can be tagged profitable only in hind sight.

No one knows in advance that his or her portfolio will do great.

However, this element of uncertainty about the end result must not stop us from following the right process to build our portfolio. 

Following the process automatically diminishes the effect of uncertainty 

And the right process to follow while building a profitable portfolio is:

I will join you in the next part with the next steps. Happy Investing!