At present, the technique of portfolio insurance is not, therefore, available to Indian
investors who will, for some time to come, have content themselves with the simpler
method of defensive portfolios.
Scrip Selection
Having determined the desired beta of our equity portfolio, the next task is that of
constructing a well-diversified portfolio with that level of beta. In theory, the most
perfectly diversified portfolio is the one which contains every security traded in the stock
market. Such perfection, however, is only an ideal, not to be achieved in real life^1. In
practice, one needs a much smaller number of securities to achieve a very high degree of
diversification: 15-20 securities may often be adequate, though large institutional
investors may use 40-100 securities. But care must be taken to ensure that the securities
one chooses are spread over several industries. Excessive dependence on any one
business group or geographic region must also be avoided. Within these limits, the
investor has considerable leeway in choosing a diversified portfolio.
In addition to diversification, there are two other factors to be considered in designing a
portfolio. First is the issue of market timing to which we have devoted a section earlier.
Market timing requires us to temporarily shift to offensive or defensive portfolios
depending on our view of the market. Second, in the chapters on fundamental and
technical analysis, we have discussed the various methods that analysts use to determine
whether a stock is under or overvalued. One expects undervalued stocks to rise and
overvalued. One expects undervalued stocks to rise and overvalued stocks to fall as the
market corrects itself. Obviously, scrip selection must use this information. The
undervalued stocks are to be sought and the overvalued one is to be shunned. But again
there is a danger: the analyst may identify two or three stocks that are very good buy and
may invest heavily in them. The resulting portfolio may be very poorly diversified. This
is a danger that portfolio theory teaches us to avoid.
To see how these two factors influence the scrip selection problem, we now look at four
types of investors and examine the portfolio design approaches suitable for each of them.
1 In many foreign capital markets, it is possible to buy index contracts which give
the investor the same return as what he would have got by investing in the entire market
portfolio. Index contracts are not available in India, but some investors use UTI
Mastershares and similar instruments as surrogates for an index contract.