Let’s say you have ₹ 1 lakh to invest in 10 different stocks.
You like Reliance Industries a lot and decide to invest 10% of your money in it. You are not so bullish on banks, but still want to have HDFC Bank, so you allocate 1%.
In numbers, it would be 10,000 invested in Reliance Industries and 1000 in HDFC Bank.
A day after you invest, Reliance Industries rises by 2%. The value of your portfolio has increased by 200.
On the same day, HDFC Bank rises by 10%. But the value of your portfolio has only increased by 100 rupees.
After a year, Reliance Industries has gone up by 25%. The value of your portfolio would’ve increased by 2500.
HDFC Bank has given 50% returns. The value of your portfolio has only increased by 500.
High allocation in high conviction stocks is the key to performing well in the stock market.
It’s the performance of the entire portfolio that’s important. Not a single stock.
For your portfolio to do well, the stock where you have given highest allocation has to perform.
Only if Reliance Industries does well, your portfolio will do well.
Even if HDFC Bank outperforms and gives excellent returns, it won’t make much difference to your portfolio – as the allocation towards HDFC Bank is low.
Some people make the mistake of over diversifying with 50-60 stocks in their portfolio and others have concentrated portfolios of just 4-5 stocks.
Both can be risky.
When you have too many stocks, you lose control over your portfolio. You cannot track all companies. Also, low allocation (HDFC Bank example above), is useless.
When you have just 4-5 stocks, the risk you are taking is too high. If one of those companies fail, you will end up losing 20-25% and recovering this will be very difficult.
The important thing is balance.
Your allocation towards one stock should neither be too high nor too low.
If you have a stock where your allocation is less than 3%, it means you have less confidence in the company. Avoid investing in it, buy more shares of companies that you already own.
4-5% is ideal allocation on a well-researched stock and even if you are extremely bullish – never cross 10% allocation in a single company.
Following this, will help you reduce your risk and also give you a chance of outperforming the market.