InvestorQ : What is meant by portfolio review and what is the importance and relevance of portfolio review?
Priyanka N made post

What is meant by portfolio review and what is the importance and relevance of portfolio review?

3 years ago

Creating a portfolio is just one part of the story. The bigger challenge is to put in place a mechanism for continuously reviewing the portfolio and making changes where required. Portfolio review is not akin to portfolio rebalancing. In portfolio review, you just review the portfolio on some set parameters. This may or may not result in rebalancing. The objective of review is just to satisfy yourself that you are on target to reach your goals and the milestones are in order. For starters, let us restrict our definition portfolio review to merely your equity portfolio. Creating an equity portfolio is just once part of the story. It is essential to constantly review your portfolio. Portfolio review can be based on macro factors or based on micro factors. Normally, portfolio review is a regular exercise that is undertaken every year whereas rebalancing may actually happen less frequently. Here are 6 things you need to keep in mind or rather 6 questions you need to answer while reviewing your portfolio.

Is your equity portfolio adequately diversified?

This is a fundamental question that you constantly ask in your portfolio review. It is possible that you like a stock or your advisor recommended the stock to you. The stock may have performed well in the past and hence you must have exposed a substantial part of your portfolio to that particular stock or even to a sector. You may be overly exposed to specific sectors / industries. For example, you may have bought IT stocks aggressively when the valuations were cheap and frontline stocks were available at fairly attractive prices. The net result may be that you end up overexposed to a single sector. The third reason for over concentration may be due to a sharp rise in prices. Certain stocks or sectors in your portfolio may have gone up sharply in the last few months. As a result, in value terms, these stocks may be occupying a greater share of your overall portfolio. All these situations call for a review of your portfolio. You need to review your overexposure and take a decision on cutting down and re-allocating accordingly.

Do the current macros justify your current exposure to equities?

At a macro level, there are a lot key factors that influence equities. For example, equities tend to do well when the GDP of India is growing at a rapid pace. Equity has always performed much better when GDP is growing at a real rate of 9% as compared to when it has grown at 6%. Secondly, inflation and interest rates matter a lot. Generally, equities in India have done much better when inflation has been low and interest rates have trended downward. Hence you need to increase your equity exposure to the higher end of the spectrum when the inflation and interest outlook is favourable. The converse holds true when your outlook for inflation and interests is negative.

Does my equity portfolio fit into my overall financial plan?

This is, in a way, a combination of the first 2 points and also a logical extension of the above. But this is an extremely important question to pose on a continuous basis. It needs to be remembered that you need to start off with your overall financial plan after identifying your goals and allocating resources towards these goals. Within your overall allocation, you have equity, debt and miscellaneous assets like gold and property. When we are referring to your equity portfolio, we are referring to it as part of your overall financial plan. Normally, a financial plan allocates based on your return requirement, risk appetite, liquidity needs and tax status. The discipline you need to maintain is that your overall allocation to equities must not diverge away from your overall financial plan. If that be the case, then you need to bring down your equity allocation overall and reallocate to debt or other assets.

How is my portfolio performing versus the benchmark?

This is a very important review you need to undertake. The whole idea of creating and nurturing your portfolio is to ensure that it creates wealth for you in the long run. For that it must consistently beat a benchmark. Don’t get obsessed by 3-month and 6-month returns. But over a 3 year period, your equity portfolio should be doing better than the index. If that is not the case, then you are better off being in an index fund or in an index ETF. Portfolio review also focuses on the quality of the benchmark. For example, if your portfolio is heavy on mid-cap stocks and small-cap stocks then benchmark against the mid-cap index and not a diversified index like the Nifty or Sensex. That will give you a better picture of your portfolio performance. Ideally, what should be done in a portfolio is to calculate 3 year rolling returns each quarter and evaluate over 10 quarters. If in majority of the quarters the portfolio is outperforming the index benchmark then it is acceptable. But if the portfolio underperforms in most of the quarters then there is a need to rebalance. That is not a good message for consistency and becomes too contingent on the timing of entry.

Are the returns commensurate with the risk you are taking?

Taking on risk is the key to higher returns, but your returns need to be measured and calibrated. This is a very important criterion and is known as “Return per Unit of Risk”. We had understood the point of benchmarking return. But you must also understand how to benchmark risk. If your portfolio has earned higher returns by buying low quality stocks, then your return per unit of risk has been lowered. If your portfolio has earned higher returns by concentrating in a few stocks or sectors, then again your return per unit of risk has been lowered. If you earned higher returns by buying too many small and mid-cap stocks then your return per unit of risk is lower. You constantly need to evaluate your portfolio with respect to how much risk you are assuming to earn those returns; and whether it is really worth it? If the index with a beta of 1 is earning 14% and if your portfolio with a beta of 1.5 is just 15% then you are being underpaid for the risk you are taking. Your portfolio needs a tempering of risk.

What are the winners in your portfolio that will create the alpha for you in future?

This is probably the most important question from your long term portfolio point of view. It rarely happens that all the stocks in your portfolio will outperform. There will be laggards, there will be market performers and then there will be a few superstars. How do you include superstars in your portfolio is the big question. Simply put, you need to invest in stocks that could become great performers in the next 5-10 years. Outsourcing through IT was a great futuristic story in the mid-1990s. Not surprisingly, IT stocks were multi-baggers in the next few years. Consumption was a big theme in mid-2000s. Most consumption stocks did extremely well in the next few years. You need to constantly look at themes. For example, digital money may be the big theme today. You need to start asking about the big themes to benefit and whether they have the robust business models to support them? It is when you ask this question that you get multi-baggers in your portfolio. You obviously cannot have too many alpha stocks and hence the idea is to hold on to these alpha stories long and hard to make enough money.

How often should one review one’s portfolio? For a long term portfolio it does not make sense to evaluate too often. However, alerts can be set up to red-flag when any key shift crops up. Reviewing your portfolio along pre-set criteria can go a long way in creating wealth over the long term. The thumb rule is that an annual review is good enough.