Need for Portfolio Construction
Why can't we just pick the "best" stock and invest all our money in it? Because even the best companies can fail, and single-stock risk is enormous.
The Problem with Single-Stock Investing
Example: Nokia
In the early 2000s, Nokia was the world's largest mobile phone maker. An investor who put all their money in Nokia in 2007 would have lost 90% by 2012 when smartphones took over.
Lesson: Even "safe" stocks can collapse.
Types of Risk
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How Diversification Works
When you hold 20-30 different stocks across different sectors:
- If one company fails, it's only 5% of your portfolio (1/20).
- The losses are offset by gains in other holdings.
The Math Behind It
Risk of a portfolio is NOT just the average of individual risks. It also depends on Correlation.
- If two stocks move together (Correlation = +1), no benefit.
- If they move opposite (Correlation = -1), perfect hedge.
- Most stocks have Correlation between 0 and +0.7.
Research Finding: A portfolio of 20-30 stocks eliminates about 70-80% of unsystematic risk. Beyond 30 stocks, the marginal benefit of adding more decreases.
Why Not Just Buy an Index Fund?
Good question! Index funds (like Nifty 50) are already diversified. But portfolio construction allows for:
- Customization: Tilt toward growth vs value.
- Tax Efficiency: Harvesting losses.
- Active Management: Beating the index (if skilled).
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