How Defensive Investors can Diversify Investment Portfolio?

I once read this topic on “how defensive investors can diversify investment portfolio” in a book called The Intelligent Investor.

This topic was covered in Chapter 4 of the book, whose heading was, “General Portfolio Policy: The Defensive Investor”.

It is a fantastic book, written by the legendary Benjamin Graham.

He was the Guru of Warren Buffett, and is often referred to as the father of value investing.

The Intelligent Investor (book) is almost like a Bible for Value Investors.

The Chapter 4 of this book is very interesting. Why?

Because it talks about some rules which exactly suits people like me.

Who are “people like me”?

Careful, watchful, defensive, detailed who like passive investing more than active investing.

Why are these people defensive? Lack of knowledge, time…?

In many case the answer is yes. But there could be other reasons. I can speak for myself.

When I invest passively & carefully, it seems like working within my comfort zone.

It pays more, when people work consistently, watchfully and intelligently within one’s comfort zone.

How to invest within comfort zone?

This is tricky. It is not as easy as it sounds.

It becomes particularly difficult for “people like me”.

We also want higher returns, but has lower risk appetite.

People who are flamboyant, can take instinctively more risks.

But we cannot act like them. We do not have that personality.

We are more drawn towards watchfulness and low-risk zones.

Here in chapter 4 of The Intelligent Investor, Benjamin Graham almost nailed it for us.

He explained the theory of portfolio diversification.

How to invest remaining within ones comfort zone, and still do it effectively.

The logic is, if ones portfolio is diversified well, he/she can stop bothering about the potential risk of loss.

More focus will be on selecting quality stocks, bonds etc. This makes investing more effective, right?

In a well diversified portfolio, the contents & its proportion takes care of the risks.

The investor need not bother.

What is essential though are the following:

  • Maintaining an optimum balance of portfolio.
  • Ensuring only quality assets are included in portfolio.

What means by balance of portfolio? Diversification.

In Chapter 4, Benjamin Graham has explained to near perfection, how defensive investor can diversify investment portfolio.

Read more: Diversification is a strategy to reduce risk of loss.

What is a comfort zone?

You might have heard about this common concept quoted by many experts of equity. It says:

“If ones desire is to earn high returns, he/she must be ready to take more risk”

Benjamin Graham has a different view on this. He says:

The rate of return sought, should be dependent on the amount of “intelligent effort” the investor is willing and “able to deliver”.

Here the keywords are two:

  1. Intelligent effort.
  2. Able to deliver.

Now here comes the role of “comfort zone”.

To ensure intelligent effort & delivery, one must have the following:

  • Interest & desire to learn.
  • Time for learning.
  • Implement the learnt concepts.
  • Observe the outcomes.
  • Improve further.

Remember that, what we are talking about here is “investment of money in stocks”. It is a niche activity.

Not many will find it interesting to go in such depths of it.

Yes, they want to invest in stocks, but it doesn’t mean that they would also like to indulge in the whole process of stock analysis.

Such analysis may not be in the “comfort zone” of an individual. This is natural and perfectly human.

Such a person can be tagged as a passive investor.

These people should be contented with average returns.

Whereas a similar person, may like to go deeper into stock’s-study and its implementations.

Such a person can be tagged as active investor.

They can earn more than average returns.

Who are active and passive investors?

Both of them are intelligent investors. How?

Because by being aware of who they are, they conciously decided to invest within their “comfort zones”.

Yes, not crossing the boundaries of one’s comfort zone is key in equity investing.

The clearer are the boundaries, wiser will be the investment choices.

And when the choices are right, returns are more assured.

So it is essential to first look deeper into self, and then tag oneself as one of the following:

  1. I am an Active (enterprising) investor.
  2. I am a Passive (defensive) investor.

Once you are done tagging yourself, note what must be done as a active and passive investor.

Active Investor:

  • Research stocks (always).
  • Pick good stocks out of research.
  • Keep a close watch on holdings (portfolio).
  • Reshuffle constituents as and when required.

Passive Investor:

  • Research stocks (once in a while).
  • Pick good stocks out of research.
  • Portfolio runs on auto-pilot.
  • Reshuffle constituents (once in 6/12 months if required).

So you can see that, both active and passive investors are not very different.

The only notable distinction is, active investors are more involved than passive investors.

What is investment portfolio diversification?

It means, answering the below two questions?

  1. How much to invest in equity (stocks)?
  2. How much to invest in debt (deposits, bonds etc)?

Apart from equity and debt, there are other investment avenues like Real Estate, Gold etc.

But to get the concept clear, lets stick with equity and debt for the moment.

What is equity? That investment options that post a bigger risk of loss.

What is debt? That investment options with guaranteed returns.

If it is so, why one will invest in equity?

To protect oneself from the wrath of inflation.

So why not, invest only in equity?

Because 100% equity will not be in the “comfort zone” of defensive investors.

So what should be the ideal mix?

This is what Benjamin Graham beautifully explains in Chapter 4 of The Intelligent Investor.

Graham says, Keep a minimum of 25% in debt. Balance in Equity

A minimum of 25% in debt must always be maintained. Why?

Because this will give enough confidence to the person to invest & hold the balance amount (75%) in equity.

But depending upon one’s comfort, the percentage between equity and debt can vary.

Just for Example:

DescriptionEquityDebt
A Newbie Bachelor75%25%
Just Married60%30%
Planning babies45%55%
Kids going school50%50%
Kids in college40%60%
Kids settled65%35%
Before Retirement50%50%
After Retirement25%75%
Non Finance Professional50%50%
Banker65%35%
Financial Advisor60%40%
Skilful in stock analysis75%25%
High Net Worth70%30%
Middle Aged, no experience in stocks50%50%
Middle Aged, with experience in stocks65%35%

Just give a glance to the above examples.

Try to judge, what mix of equity and debt suits you the best.

Remember, idea is to always invest within one’s comfort zone.

What is comfort zone? Investment portfolio made up of a perfect proportion of debt and equity (eg: 50-50).

How to get the perfect proportion?

Ask the following questions to yourself.

Better will be to open a personal diary, and start to write a small paragraph against each question.

If you can also quantify your answers in numbers, it will be better.

More precise will be the answers, better will be the clarity on the split between equity and debt.

#1. Are you a bachelor.

#2. Out of total household income (100%), how much comes from spouse?

#3. Do you have children?

#4. When you are planning to have child/another child?

#5. How much is your fixed/compulsory expenses?

#6. How much you spend on comfort and luxuries?

#7. Out of total household income (100%), on an average, how much is saved each month?

#8. How old are your parents? How soon you are expected to take care of them?

#9. Are you going to inherit something from your parents?

#10. How stable is your income (job/business)?

#11. Do you like your work?

#12. You would like to invest your saving to generate income? (Note: only debt plans can generate stable income).

#13. How much money you can afford to lose each month without being psychologically or financially disturbed?

#14. Do you feel comfortable seeing a falling market?

#15. Do you have enough time, out of your work, to give attention to your investment portfolio?

So this is all.

Some of these questions has been reproduced as it is from the Chapter 4 of The Intelligent Investor.

Some questions, I have added from my side as it works for me.

I am sure, once you have answered these 15 questions, you will know your right mix of equity and debt.

What mix I follow?

Myself, being a full time blogger who consistently read and write on topics of investment and personal finance, it helps my cause.

I prefer a equity heavy investment portfolio.

But I make sure that my investment portfolio is always balanced (right mix of equity and debt).

Keeping portfolio always balanced is key…how?

Defensive investors can diversify investment portfolio by ensuring a right mix of equity and debt as its constituents.

But this portfolio mix will not remain same always. How?

Let’s take an example:

Suppose you are a defensive investor, whose portfolio composition looks as below:

BeginningAfter 3 years
StocksRs.100,000 (50%)Rs.140,000 (56%)
Debt Mutual FundRs.100,000 (50%)Rs.108,000 (44%)
Rs.200,000 (100%)Rs.248,000 (100%)

In the beginning, when you started investing, the portfolio balance was maintained as:

  • Equity-Debt: 50-50.

But over a period of time, with stock market rising, the portfolio balanced changed as:

  • Equity-Debt: 56-44.

What should the investor do now?

Normally what we do is different from what Benjamin Graham is suggesting.

I personally feel that this is a masterpiece advice by Graham.

Though the thought is simple, but in its simplicity lies the immaculate intelligence.

Benjamin Graham suggests to rebalance the portfolio. How?

Two steps:

  1. Sell Stocks.
  2. Buy Debt mutual fund units.

What is the total portfolio value now? Rs.248,000.

Means, the equity and debt split should look like this:

  • Stocks: Rs.124,000 (50%). At present, you have an excess of Rs.16K here.
  • Debt Fund: Rs.124,000 (50%). At present, you have a deficit of Rs.16K here.

What does it mean?

You must sell Rs.16,000 worth of shares, and buy an equivalent amount of debt based mutual fund units.

How often one must rebalance ones portfolio?

Frankly speaking there are no rules.

I will speak what I feel comfortable about.

Checking once portfolio constituents must be done every 6/12 months.

More often than not, you will find your stock valuation in negative. Do not panic.

Instead, this is time where you can buy more equity. Why?

Because your portfolio balance is asking you to do it. How?

Lets understand it with examples:

Example: Case 1

Beginning (Past)After 6 months (Present)
StocksRs.100,000 (50%)Rs.95,000 (48%)
Debt Mutual FundRs.100,000 (50%)Rs.103,000 (52%)
Rs.200,000 (100%)Rs.198,000 (100%)

At this present time, your equity-debt balancing should be like this:

  • Stocks: Rs.99,000 (50%).
  • Debt Fund: Rs.99,000 (50%).

So what needs to be done?

Step#1: Sell debt funds worth Rs.4,000 (99,000 minus 95,000).

Step#2: Buy stocks worth Rs.4,000 (103,000 minus 99,000).

Example: Case 2

Suppose you have additional funds worth Rs.10,000 available for investing.

Present portfolio composition looks like this:

Beginning (Past)After 6 months (Present)
StocksRs.100,000 (50%)Rs.95,000 (45.6%)
Debt Mutual FundRs.100,000 (50%)Rs.103,000 (49.6%)
CashRs.0Rs.10,000 (4.9%)
Rs.200,000 (100%)Rs.208,000 (100%)

In terms of following a 50-50 diversification rule, in the present situation the composition is not balanced., right?

What will be a balanced composition?

  • Equity: Rs.104,000 (50%).
  • Debt: Rs.104,000 (50%).

What can be done?

Stocks worth Rs.9,000 (104,000 minus 95,000) must be additionally purchased.

Units of debt funds worth Rs.1,000 (104,000 minus 103,000) must be additionally purchased.

Buying like this will bring the investment portfolio back to a balance of 50-50

Beginning (Past)After 6 months (Present)After Current Purchase
StocksRs.100,000 (50%)Rs.95,000 (45.6%)Rs.104,000 (95,000+9,000) (50%)
Debt Mutual FundRs.100,000 (50%)Rs.103,000 (49.6%)Rs.104,000 (103,000+1,000) (50%)
CashRs.0Rs.10,000 (4.9%)Rs.0
Rs.200,000 (100%)Rs.208,000 (100%)Rs.208,000

Example: Case 3

Suppose you have additional funds worth Rs.10,000 available for investing.

Present portfolio composition looks like this:

Beginning (Past)After 3 years (Present)
StocksRs.100,000 (50%)Rs.140,000 (54.2%)
Debt Mutual FundRs.100,000 (50%)Rs.108,000 (41.8%)
CashRs.0Rs.10,000 (4.0%)
Rs.200,000 (100%)Rs.258,000 (100%)

In terms of following a 50-50 diversification rule, in the present situation the composition is not balanced., right?

What will be a balanced composition?

  • Equity: Rs.129,000 (50%).
  • Debt: Rs.129,000 (50%).

What can be done?

Stocks worth Rs.11,000 (140,000 minus 129,000) must be sold.

Units of debt funds worth Rs.21,000 (129,000 minus 108,000) must be additionally purchased.

Buying like this will bring the investment portfolio back to a balance of 50-50

Beginning (Past)After 3 years (Present)After Current Purchase
StocksRs.100,000 (50%)Rs.140,000 (54.2%)Rs.129,000 (140,000-11,000) (50%)
Debt Mutual FundRs.100,000 (50%)Rs.108,000 (41.8%)Rs.129,000 (108,000+21,000) (50%)
CashRs.0Rs.10,000 (4.0%)Rs.0
Rs.200,000 (100%)Rs.258,000 (100%)Rs.258,000

Final Words…

How defensive investors can diversify investment portfolio?

By following a rule of equity-debt balancing (say 50-50).

A practical procedure for maintaining a diversified portfolio has been explained above.

But I would like to highlight two critical checkpoints here:

  1. Which stocks to buy?
  2. How soon to rebalance?

Here it must be noted that one cannot buy any stocks.

Just because your portfolio balancing is asking you to buy more equity, it does not mean that one can buy any stocks.

Equity Purchase (Which stocks to buy?)

If one is not in situation of doing stock analysis by self, indirect equity investing should be practiced.

No need to buy stocks directly.

What are indirect equity purchase options?

  1. Index funds.
  2. Index linked ETF’s.
  3. Multi Cap mutual funds units etc.

How soon to rebalance?

Rebalancing is very important. But it must not be done too often. Why?

Here we are dealing with equity. In equity, volatility will always be visible.

Equity must be given needful time to show results.

In case the equity price has moved up, decision is easy. Book profits (to keep 50-50 balance).

But when price falls, suggestion is not to take any panic decisions.

Act what your 50-50 portfolio balancing rules asks you to do (See above examples, case-1,2&3).

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