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Tuesday, July 12, 2011

How many stocks should I buy?

From the emails I receive from readers and newsletter subscribers, this is a common question faced by many small investors. Due to limited resources, investors tend to swing from one end of the buying pendulum to the other. They either buy 30 shares of a fundamentally strong stock trading at Rs 500; or, they buy 500 shares of some unknown small-cap trading at Rs 30.

Both can be counterproductive for the growth of your portfolio. With the costlier stock, a sudden spurt to Rs 600 may tempt you to sell out quickly and miss a bigger profit opportunity. The alternative strategy of booking partial profits and holding the rest with a trailing stop-loss may not work too well with only 30 shares to play with.

For the less expensive stock, a 20% gain from 30 to 36 may not seem enough to do any profit booking. So you hold on with the hope of selling only if the stock reaches 50 – which it may never do. In fact, the cheaper stock is more likely to drop to 15.

What is the solution? Firstly, you need a decent amount of capital to build a portfolio of individual stocks. I recommend a minimum of Rs 5 lakhs – preferably Rs 10 lakhs. What if you have only 1 or 2 lakhs? You may be better off investing in mutual funds and fixed income instruments to build up your capital.

What if you do have Rs 5 lakhs? How do you decide how many stocks to buy? The thumb rule in buying individual stocks is: More is not merrier. Keeping regular track of any more than 10-12 stocks can become a full-time activity. You have to remain informed about the overall economy – local and global, individual sectors to which your stocks belong, quarterly performance of individual stocks as well as news flows about them; read Annual Reports; check if dividends are getting credited; apply for rights shares, and a myriad other things.

If you settle on 12 stocks for your portfolio, how will you allocate to large, medium and small-caps? A thumb rule for getting steady returns, protecting downside during bear attacks, plus having a growth ‘kicker’ is to allocate 80% of your capital into stalwart large-caps, and 20% to good mid-caps and small-caps.

How many stocks in each category? Say, 8 large-caps, 2 mid-caps and 2 small-caps. Allocating Rs 50000 for each large-cap, and Rs 25000 to each mid-cap and small-cap stock will complete your portfolio. This is a suggested portfolio. You can tweak it to suit your own style and risk tolerance.

Once you limit yourself in terms of the number of stocks and the allocation of capital to each stock, a funny thing will happen. You will be forced to be very selective about the stocks you pick. That will, in turn, make you more disciplined about choosing the very best stocks – and waiting to buy them only after a significant price correction.

The same Rs 500 stock mentioned earlier was probably trading at Rs 200 two years back, and may drop to 350 after the next correction. Instead of buying 30 shares now, buy only 10 (to help you to track it regularly). When (and if) it drops to 350, buy 130. You will end up with 140 shares and complete your Rs 50000 allocation to the stock.

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