Finding stocks for your investment is the first step to build robust portfolio. Determining the size of each stock in your portfolio is the second critical step. Today I will share with you few insights on how we manage our portfolio professionally.

Before we go ahead, it is important to read part one and part two of this series to have a better understanding of this post. So far we were talking about how to position individual stocks but in this post we will talk about risk management practices and how each individual stocks interacts with other stocks in the portfolio.

To begin this discussion, it is important to know certain structural risk management limits that we apply in managing our portfolio. We categories these limits into two, soft and hard limits. At individual stock level, we have hard limit of not investing more than 10% of our assets. These limits are self-imposed and are designed in such a way that it allows us to express our conviction in any investment idea. This helps us also to acknowledge that things can and do play out differently to the way we might expect.

To give you example, two years back we had a strong conviction (9 out of 10) that JK bank is a good investment idea as its NPA’s are all under control compare to its peers and bank will enjoy stable and healthy earnings. Then suddenly we heard about NPA issues clouding above JK bank and our conviction level fell down from 9 to 7 level. Straight away we had to do haircut of our JK Bank position in our portfolio. After every quarter results our conviction level started falling down, and before we liquidate our entire position from JK bank, our conviction level was sitting at level 2. This practice helped us to cut down our losses and preserve our capital. In other words, think of it as an act of humility in a business where over confidence has a way of being harshly punished by the market.

Beyond individual stock limits we seek to selectively diversify the portfolio by industry. In other words we are not interested to diversify our portfolio for the sake of it, or trying to match the industry weighting of broader equity market. We rather want to choose best risk/reward opportunities for our portfolio if they happened to stacked in any certain segment. Again as an act of humility and to protect against unexpected occurring in any one sector, we have introduced a soft industry exposure limit.

Typically that soft exposure to any industry or sector is 30%. So it means that once we have reached that soft limit in any particular sector, a new attractive investment idea in same sector will have to take position of existing position. We normally try to avoid such situation. As a chief investment officer for the funds, I would prefer to utilize our resources and research team efforts to other sector where we are more readily able to divide exposure when we find good opportunities rather than substitute them.

As an example, information technology sector in aggregate accounts for 35% of soft limit in our portfolio. There is a big list of businesses that we like in this sector. If we already have 25% of our portfolio exposure on this sector, we might pick one or two stocks from the list. To select which one, our conviction level helps us to select. We prefer to invest in our highest conviction investment idea.

Sector definitions are broad and often not an actual reflection of the risks we have assumed or the earnings drivers of the business. Take for example today, we do not like our portfolio in the IT sector to exceed more than 30%. Similarly we do not prefer our exposure to finance sector more than 30% looking at the growth prospects. NBFC (Non-banking financial company) also represent within financial sector and at one stage we only had 5% of exposure to it. But today our exposure to NBFC had doubled. So if there is any new opportunity available say from within any banks to invest with, we will have to replace one from the existing. If we are not inclined to do that then that business is added into our watchlist and wait for any material change in our portfolio.

We hope that you liked this series on how to size your stock for portfolio. The roadmap we developed in this series combining valuation outcomes with conviction levels has helped establish an appropriate position size for stock in isolation. However, this process must be complemented by a nuanced understanding and aggregation of the specific risks underlying the holdings to further augment position sizes and achieve an optimum risk/reward balance across the entire portfolio.

Aziz Dodhiya is the chief investment officer for the Valueoperations funds which operates in the Indian market as an FPI (Foreign Portfolio Investor). We do not offer any personal advice to buy or sell any stocks and the views that are shared by Aziz might not incline to your personal investment strategy and this is the reason we tell you to take professional advice before going ahead with our views.