About 20 years ago, I asked for advice from a close friend and guide, about what and where to invest successfully. Till then ofcourse I had no knowledge about picking stocks and like most beginners I had entered the market at its highest point, expecting to make a fast buck. Needless to say most of my investments were languishing at the time.
I recall vividly that my learned friend calmly looked at the list of my investments (which were quite a few in number, though small in value) and commented that with the number of stocks that I had, I could well be a mutual fund. I wondered at the time what he meant.
I figured that much later. This article will delve into a very important aspect of investing: How much diversification to target when investing in stocks. There are many views on this but the one that I have to come believe as the best, is what I will describe in this article. I also have to admit that I took long to appreciate the concept and so I understand fully how difficult it is to EXECUTE, mainly due to our mental blocks – even though it may be easy to read and understand. (But before giving up on it, please read and understand it!).
$$$$$$$$$$$
The concept starts with the understanding of a simple home truth. You don’t get rich on percentages. You get rich by the actual cash. If Warren Buffett is rich, it is not only because he has had a compounded return 25% (or so) on his investments. It is because he has $45bn of net worth to prove it.
In yet other words, if one invested in a good stock and got a return of 100%, then that may not necessarily mean that one got rich. Richer, yes. But not necessarily rich. To become rich, one has to put a larger AMOUNT of money behind that idea.
Conservatism, though, can come in the way of implementing this simple idea. One is not sure of one’s own abilities to pick the right stock. And if that is the case, then for sure diversification is the right answer (though if one is not sure, then investing is a bad idea to start with).
But if one does discover a gem – which happens every once in a while – then adequate fire power needs to be put behind that idea. And the surer you become of the idea, the larger the amount that needs to be put behind it.
The Great Gambler
Although I still slightly hate that comparison, I hesitatingly do admit that gambling and investing CAN be similar in some respects. Warren Buffett and fellow billionaire Bill Gates are obsessive bridge players, and one of Warren's boyhood business ventures was selling horse-race tip sheets. Also, Pimco's Bill Gross, widely acknowledged as the world's greatest bond mutual fund manager, started his career as a professional blackjack card counter in Las Vegas -- an experience he believes contributed greatly to his success.
If one sees a gambler spreading their chips over virtually the entire table, then this should tell you that they have no idea what they are up to. Although such a gambler would have a high frequency of winning, they would also have a low payoff because their losses (with the other chips that didn’t win) will offset their winnings. Very similar to an investor who talks about how one of their stocks shot through the roof, only to confess later that unfortunately they had invested very little in that stock. (sound familiar?)
The similarity between winning in both investing and gambling, can then be described in terms of understanding what probability one has of winning. And then putting an appropriate amount on that winning position so that the overall profit is substantial.
The Kelly formula
One way to figure this is the Kelly formula, created by John Kelly, an American scientist. The formula simply states that an investor should calculate edge divided by odds to determine how much to invest in a security.
The formula (edge/odds), in expanded form, is: (P*W-L)/P. In this formula, P is the payoff, W is the probability of winning, and L is the probability of losing.
Here, the P (payoff) in the formula is how much money you'll make or lose for every dollar you invest. In investing terms, if you think a stock can triple, then you're getting $2 in profit for every $1 you invest, so the payoff is $2*.
If with experience and your informational advantage you know that the probability of that happening is say 60%, the amount one should put behind this idea is as follows:
($2*60%-$1*40%)/ $2 = ($1.2-$0.4)/ $2 = 0.40 or 40% of your investible surplus.
This then becomes the maximum amount that can be invested.
Warren Buffett, without ever describing his technique as the Kelly formula, had invested upto 40% of his net worth into a single idea – American Express Bank, which later prospered.
Charlie Munger, describes this thought as follows:
“The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.”
* Note that the assumption in the formula is that if you lose, the loss is 100%, which is actually never the case – hence there are limitations to the formula’s usage. Hence, we could imagine a more likely scenario in the stock market as below:
Probability of having a gain of 50% on your investment = 60%
Probability of having a loss of 30% on your investment = 40%
The way to recompute the odds in this case would be to bring down the ratio of gains to loss to a simpler form. Hence a 50 (gain):30 (loss) should be restated as odds of 1.66:1. The Kelly formula can now be used as follows:
(1.66*60%-1*40%)/ 1.66 = (0.996-0.40)/ 1.66 = 35.9%
My own technique
For many reasons – one of which being that I am not Warren Buffett, I have always found it easier on the mind to invest upto a maximum of 10% of my investible surplus as I become surer of the investment idea. This means that I can often start with a smaller amount, especially if I think that there is an opportunity to achieve a better price compared to the existing price. If the price falls, I stock upto 10% of my investible surplus on that idea.
(Note though, that I don’t let the concept become a fetish. For instance if the price of the stock goes up, I don’t sell some of the stock just to ensure that the stock remains at no more than 10% of the investible surplus. On the other hand, there are times where I have broken the 10% rule and invested higher than 10%, especially if the price has fallen. This lets me average the price down, when I am sure that the investment idea is still valid.)
Number of stock holdings and conclusion
If one does invest bigger amounts on a single, sure idea, then by definition, one should NOT have too many stocks on one’s portfolio. If all stocks are invested upto 10%, then a maximum of 10 stocks would form the portfolio. It could be extended to, say, upto 20 stocks as some stocks could just be toe-holds.
Compare that now to the number of stock positions that the average mutual fund has. Is there ANY mutual fund that has 10% in even one stock? Not many. No wonder then, that a large number of mutual funds lag in performance even when compared to the stock market returns over a longer period of time.
The final word then is - don’t try to be a mutual fund! They are not worth being the benchmark.
Good stock ideas are rare – they should be. But when you do get them, put enough resources behind them and reap the benefit.
As a parting shot, a joke on Mutual Funds:
A customer asks a fund manager: “The markets are down 10% and the fund is down 12%. I thought you said that the fund is market neutral?” The fund manager replies:
“Sir, the fund is market neutral. We still make our 2% no matter what the market is!”
Happy investing..
