Any long term investor will know that they need to manage risk in their portfolio. The way individuals should manage their risk is asset allocation and diversification. Today, I am discussing how I manage risk in our income portfolio. The objective of this risk analysis is to make sure that TIP portfolio is not exposed to any particular event, or company, or any other aspect that will affect portfolio performance.

My portfolio management process has a risk management process in which I try to:

1. Maintain pre-determined asset class allocation;
2. Maintain pre-determined diversification, any sector should not exceed 10%;
3. Any single stock should not exceed 7% of the portfolio;
4. Dividends from a single stock should not exceed 5% of total dividend cash flow.

Maintaining Asset Allocation

Chart 1 shows different asset classes and my target allocations. These are target levels, which allows me to maintain certain level of sanity and do not get carried away by media hypes. I am open to adapting or modifying these targets, however, such modifications are rare.

Asset Allocation - 1H09

Maintaining Diversification

For industry sectors, I have a pre-defined maximum limit of 15% for power sector, while all other industry sectors, my maximum limits are 10%. The chart 2 shows that I have higher exposure (relative to my limit) and concentrated in Diversified, Finance, Power, and Oil and Gas.

• It is suffice to say, my diversification in industry sector is out of whack. The primary reason is I added to my existing position in the month of March and April 2009.
• One would observe that these are the sectors that pay relatively consistent and higher dividends. Intuitively, this seems to be correct because, invariable in search of stable growing dividends, I end up in these sectors.

For individual stock’s value, I have a predefined range of 3% to 7% of the total equity portfolio. The chart 2 shows that I have higher exposure in five companies, while the remaining six companies are well within my targeted range.

Diversification - 1H09

Criteria of Maximum Dividend per Stock

The purpose here is to ensure that dividends from any given stock do not exceed 5% of the total dividend cash flow. This is to make sure that I am not over exposed to variability of dividends from companies. Once in a while, it is likely that company may reduce its dividends to common shareholders. In worst case, it may cut its dividends altogether. This criterion allows me to build-in that safety net for my cash flow. The chart 3 shows that I overexposed in certain stocks. Specifically, L&T and ONGC are the two stocks in which I am overexposed.

Chart 3: Diverification - Dividend Cash Flow

Lessons learned and way forward…

My quarterly risk analysis shows that I have deviated from my risk management process. I have put TIP equity portfolio at higher level of risk and it is not a good scenario that I would like to be in.

I had cash allocated to equities. When my existing positions again became attractive, I bought more of similar equities. I did not have enough time to look for opportunities in other sectors. This has resulted in higher allocation.

There are two ways to manage this:

1. Bring down the allocation by selling partial positions in ONGC and L&T. Going down this path essentially means re-balancing your portfolio. Buffett does this very efficiently. Most recently he partially sold his position in JNJ. He took cash and invested in preferred shares of GE/GS;
2. Do not allocate future capital and hence, final allocation will automatically come down.
   

The primary reason I end up in the scenario is because I did not have a watch list for my stock purchases. If I had a watch list, I would not have to worry about missed opportunities. I am now actively working on preparing my watch list.

I have decided not to make any changes in individual positions. After looking at these companies and cost basis for these stocks, I believe they will continue to grow. I also do not expect that these companies will cut their dividends by significant amount.

However, I will not be allocating any new capital (or not purchases) to these companies or sectors. I will bring my allocation to my pre-determined target by the end of this year.

I expect that with this approach to risk-based allocation, I will continue to maintain optimum potential for capital appreciation. It will also reduce my risk to dividend cash flow. This allows me to sleep properly at night knowing that even if another Satyam were to happen, it will have limited effect on my portfolio.

My current holdings are listed in My Portfolio Page.