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  • Constructing An Equity Portfolio: My Philosophy And Process 0 comments
    Nov 21, 2013 10:01 PM

    After much thought, I've decided that my first post on Seeking Alpha should be about the philosophy of building an equity portfolio for the new investor. In the competitive world of investing, it can be frightening to jump into the stock market game with limited knowledge and more importantly, little to no experience. There are a few ways to overcome these obstacles, and most of them revolve around the basic principles of managing systematic risk. To begin constructing an equity portfolio, start by collecting data on each industry sector and subsector's company universe for 1, 3 and 5-year returns, as well as collecting historical betas for these companies. Gather this data and analyze the stocks within each sector universe (in excel) and select companies that maximize the Treynor ratio (Return of Equity - Risk free rate / Beta). This exercise can also be repeated with the Sharpe Ratio or both preferably (Return of Equity - Risk Free Rate / Standard Deviation). Try to find stocks that consistently outperformed in these 1, 3 and 5-year measures. By selecting stocks that satisfy these criteria, returns are maximized per unit risk. This is the key to being an intelligent investor, since any Joe Shmoe can take on high levels of risk and therefore potentially higher returns. It is important to note that historical returns and historical betas do not determine future performance or future risk measures, but this can be used as a sufficient starting point. (I will write another article in the future about adjusting betas and predicting future returns/costs of equity). Other potential screening variables including P/E, ROE, P/FCFE, etc can be implemented if there are too many similar performing risk adjusted stocks within a sector. These stocks should be further vetted, but I'll save security analysis for another article. Next, determine a minimum of 20-30 stocks from different sectors to account for all market sectors. The minimum number of equity holdings (20-30) has been debated academically, and while there is no exact number for all economic scenarios, it is clear that diversification benefits can be seen well beyond the 20-30 holding mark. Regardless, by selecting 20-30 stocks with the maximum risk adjusted returns from different sectors, we are optimizing risk levels in relation to the number of stocks in our portfolio. If diversification was a first priority, we could easily buy an S&P 500 ETF and settle. But I would much prefer to buy the best companies from the S&P 500, rather than buying all of them. This is one of the reason I would put diversification as a second priority. The other reason is because when the stock market crashes, all stock correlations go to 1 with the market. This means diversification will not protect your portfolio from market crashes. So how can I protect my portfolio from these market crashes? (This reason alone often scares off new investors from investing in the stock market). There are a few options. The first option, stop losses, is a set price that you can select to sell your securities at when prices fall. This involves your broker constantly monitoring your stock and can be an expensive (transaction costs) and ineffective strategy. Another option is to buy put option derivatives. But this can also be a costly strategy, and can be intimidating (especially if your not familiar with derivatives). The last option is to short sell stocks, to create an appropriate hedge level. To short sell a stock, you borrow the security from a broker and then eventually buy the stock back at a lower price to close out the position, with the hope of the stocks price falling. This means one can profit from a company's stock price going down. This is the best option in terms of opportunity costs in my opinion, because it is possible to find stocks that you are significantly overvalued, providing systematic risk hedging and a rewarding investment opportunity. Short selling stocks will have opposite correlations from your portfolio, and enable you to actually lower your portfolio's beta (systematic risk). Some investors may claim that it is possible to find negative beta stocks (without short selling), but this is a common misconception. While it may be possible for a stock to have a negative beta for some extended period of time, that does not mean its beta will remain negative in the future. In all cases, negative betas are caused by unusual events or a lack of data points in a regression. To further disprove negative betas, think of it in theoretical terms. Using the Capital Asset Pricing Model as a basic measure of the cost of equity, a negative beta stock would mean the stock is less risky than a risk free asset. This is clearly unrealistic.

    It should be noted that the investment process described above is not enough to truly create alpha. Investors must understand the company sentiment, fundamentals, technicals and relating government policies before investing. While my alpha may not be statistically significant, it seems pretty real and that's good enough for me.

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