Towards a Capital Allocation Framework!

My two cents worth … first you are NOT entering a market, unless you are buying the index. You are entering specific companies. You need to look at their valuations as opposed to index valuations. Unless the index valuation is completely out of whack, a very long term correction or bear market does not follow. What you get is interim corrections of 20-40%, which last for a few months to a couple of years. The situation with Japanese stocks was that it went into a bubble and crashed and has been time correcting for the last 20 years.

There are no guarantees in the market. But since you are starting new, my suggestion would be to get started with a portion of your investible funds (say 10%) and deploy them on stocks you have studied well. Then have SIP kind of approach to deploy additional capital at regular intervals.

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That’s a valid argument but how do i know that index valuation is not out of whack? in 2008 how many people would have spotted the bubble?

your approach is sensible that i start small and as i gain confidence, i start the SIP. I read somewhere that during dot com bubble NASDAQ tanked ~60% and berkshire’s shares gained 40% over 3 years…so value buys can give +ve returns in a bear market.

Capital Protection is just as important as making money. Buying a good company at any price is not necessarily a good investment. Also limiting investments to just 5-7 companies bears more risk according to me, I believe one should spread the risk in at least 15-20 companies, limiting the exposure to max 10% in a single company and 25% in a sector.

The only way to participate in a high premium market where majority of the stocks are trading at high premium is by investing in SIP. However I choose to deploy additional amount only during correction.

Last but not the least, patience is just as equally important as discovering an idea is. Hence invest for minimum 3 years at the minimum.

My approach would be of self learning and learning from others.

First time entrants, Buy a dud stock you have no idea about in small quantity. You will soon realise your mistake, Accept the mistake, understand the follies, learn from it. Iterate over time with better stocks. This ensures you become better with time, self learn, understand mistakes of others. If you hit the jackpot in first go then you may end up well but you will develop overconfidence bias which will be killing to your portfolio.

Invest small amounts initially.

My first buy was Suzlon as a momentum trade. I looked at the Sector and went for it. Soon realised that it is under severe debt and the stock corrected 20% from my buy level. Good thing was I put little capital and did some averaging down to come to profits.

Learning: Don’t chase the stock. Learn the sector, company first even though stock price is rising fast.

Diversify well initially even though you underperform the indices. It is not the time you spend in market but accepting your follies, learn and move on that matters. Long term success comes from learning and reading, self correcting.

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We all have our individual stock portfolios. Some of us like to put small amounts into many different companies and some of us choose to put large chunks of our capital into a few select companies that we really like. This is the most essential decision that one has to make when building a stock portfolio, namely whether to concentrate funds into a few major holdings or allocate small portions of the available funds to a larger number of holdings. I’m going to talk about each approach individually and try and help you figure out what the best approach is to building a stock portfolio for the long term.

It doesn’t take a herculean effort to see what the logic is behind having a high degree of diversity in your stock portfolio. As the old saying goes “Never put all of your eggs in the same basket.” This rings true when it comes to building a long term stock portfolio too. A well diversified portfolio grants you exposure to a greater number of sectors and businesses. Moreover if a few businesses in your portfolio are doing badly, the losses from those businesses can be made up for by the profits from other businesses. This is especially true when an entire sector or two of the economy go through a period of prolonged under performance. Over the last few years years for example, the Indian IT and pharmaceutical sectors sectors have gone through a period of under performance. Those who had portfolios concentrated in these spaces naturally lost a lot more money than those who had a degree of diversity in their holdings.

But that doesn’t mean that diversification takes all the risk out of the equation. There is still the risk that your portfolio will not do as well as it could have. Lets say you have a company in your portfolio which is a proven winner with a consistent track record of robust profitability in the past. While the fact that you own the stock is a positive, you would in all probability have allocated a small portion of your funds to the stock because you have diversified into a large number of stocks, and therefore you may not make as big a profit on the stock as you may have otherwise. Diversification undoubtedly lowers your risk, but also keep in mind that when risk is lowered, returns automatically get diluted. Then there is the problem of over diversification. Buying into 30 or 40 stocks for the sake of diversification is no different from a case of too many books spoiling the broth. The diversified portfolio is therefore not meant for those who are adrenaline junkies and have a taste for reckless adventure.

So why not concentrate your funds in just a few stocks in which you have the highest conviction? After all if you’re confident about the prospects of a business and its stock, why not back it to the hilt? There’s an old Shaolin saying which says “The opponent is not under threat from the 10,000 techniques you have practiced once, he is under threat from from the one technique you have practiced 10,000 times.” In the same way, the bulk of the returns on your stock portfolios are usually made by the stocks in which you have the highest conviction and have made the highest allocation to. Therefore, having a concentrated portfolio is the best way to maximise your chances of getting a handsome return on your portfolio. But as you may have already figured out by now, your exposure in a concentrated portfolio is limited to a few companies and sectors at best, and because returns get maximised under this approach, the risk is also automatically maximised. Therefore a concentrated portfolio is definitely not for the feint of heart.

I seem to have found a solution to this entire conundrum. A portfolio structure that catches the fancy of adrenaline junkies and of those seeking a modest but steady return. This is an approach I call ‘Concentrated Diversification’. This is what I have done with my personal portfolio. I am of the opinion that a portfolio should be built like the squad of a professional sports team. Every sports team has a core team of four or five star players, another few starlets with vast untapped potential and a few weak links who are commonplace, and the maximum size of the squad is 15-20 on average. In the same way, I feel that an effective portfolio is built when it is around 15 to 20 stocks in size, but no more than 20 stocks.

This portfolio is ideally built around a core of four to six stocks where there is strong conviction with the highest allocation given to these stocks. The remaining spots can be divided between stocks which have the potential to be the stars of tomorrow and a couple of proven losers. The proven losers also have a purpose in the portfolio. You see, the losses from these proven losers will help to moderate the returns on your portfolio and may also end up giving you a certain amount of tax relief, because losses on sale of stocks cannot be taxed and can be set off against gains from sales of other stocks. The proven losers may also help in moderating your overall returns, therefore bringing your overall returns below the threshold limit for taxation.Having those 2 or 3 losers in the portfolio also helps one get used to seeing losses in the portfolio and therefore sees one better prepared and more emotionally stable to deal with the vagaries of the stock markets, instead of being pampered by exorbitant gains all the time.

The portfolio also needs to be periodically reviewed and rebalanced. To put it simply, have a look at the portfolio periodically, say once a year, and allocate more money to those businesses whose prospects have gotten better, by exiting some businesses whose prospects have gotten worse. If there is no significant change in the prospects of all the businesses in your portfolio from one review to the next, there is no need to rebalance. An overall return of 10-12% per annum on your portfolio is something you can be delighted with. Yes, inflation does have the habit of eating into your returns in the short term. But if you pick the right stocks with right allocation strategy and stay the course following the right financial discipline, your CAGR returns will more than beat inflation in the long term.

As you can now see the concentrated diversification portfolio structure brings together the best of both the diversification and the concentration approaches and therefore a large majority of both defensive and aggressive investors may find this approach more palatable than others, because there is an element of both concentration and diversification built into the portfolio structure. Also, because you know that there is an upper limit of 20 stocks to the portfolio, you are more likely to be extra cautious when picking your stocks and the businesses you want to buy into.

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Hello All,

An excellent thread and superb insights from @Donald and @hitesh2710. Thanks a lot.
Has this been captured in any excel/file for reference since I see discussion was long back in 2011 ?
And do we have made any changes or refinement to framework discussed ?

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Food for deep thought!

Link to Prof. Sanjay Bakshi’s insightful talk at OctoberQuest 2019 (here).

Position sizing… Risk aggregation… Concentration v/s diversification… Shit happens…

Read, think, digest, introspect, apply…

Thanks a ton Prof. for writing and sharing.

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The professor makes a very strong argument against concentration in the aforementioned document and this is certainly food for thought as many (incl me) have concentrated portfolios.

His view of diversification, however, means having exposure to different industries and to avoid risk aggregation as far as possible. His message that running a successful concentrated portfolio is susceptible to a blowup that happens rarely but will take you out of the game is scary but worthy of reflection.

In the end, the main takeaway is to have multiple exposures that ensure survival and not be a cowboy.

Its a good read, highly recommended.

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Absolutely enjoyed reading this - especially the illustrations of the ensemble vs time perspective that explains the concept of ergodicity with great simplicity. It was an eye-opener for me when I first came across this in ‘Fooled by Randomness’ - that every outcome should be compared with all possible outcomes in parallel universes and the sheer factor luck and randomness plays in things - until you reach what he calls ‘uncle point’ in his fantastic piece on ergodicity - the logic of risk-raking.

I had the opposite problem as I equated all risk with ruin until sometime back. ‘Love some Risks’ in the above Taleb piece sort of defines my portfolio allocations, as it has helped me differentiate between risk and ruin and try what he calls ‘convex tinkering’. It is also amazing how most of these are performed naturally by the human brain (if you let it) - calculations of ruin are performed so intuitively by the brain without the need for any math - same with Kelly’s formula - its just something that the brain performs intuitively without theory with just sheer practice. These lovely pieces theorize the technology behind it, sort of what Taleb calls as ‘lecturing birds to fly’ :slight_smile: He himself is guilty of it often.

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Nicely written… Esp in simple words and that helps relatively new investors. Nothing more to add but would emphasise a qualitative point.

  1. Having a diversified portfolio helps you retain some losers for a long time… 1 year or so. Now there is no material benefit, but it helps build the mental strength to closely see what bad stocks can do, how badly it can perform, how abysmally low it can get… All of it without actually ruining your overall portfolio.

E. G. I bought yes bank, thought I made a value buy. Saw it falling to half. Understood how retail investors always get attracted to catch the falling knife. Value pick vs value trap, bad management, media effect and so on… And then from that point it fell by another 50%. Exited after 12 months… But still in the game because of diversified portfolio. Had this been a. Concentrated one, I would have been out of the game altogether.

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Compelling arguments for diversification. The simile of the dice game is very convincing.

A simplistic takeaway from this article - even if there is a small probability of a big loss, it is a doomed portfolio. Does a diversified portfolio completely eliminate the possibility of a big loss? Maybe it does, but the key question is - how to diversify to achieve this objective.

It is always a treat to get insights from Prof. This June, I attended his Behavioral investing course at Flame university Pune and those were 4 amazing days of learning.

In my opinion, for small retail investors who have a limited capital, diversification is not going to turn around his fortunes. You got to take some courageous allocation in your conviction in order to generate wealth.And only 1 or 2 picks can do that. Else a 5% allocation no matter if it becomes 10/20 bagger is not going to impact much.
But definitely, if the corpus becomes huge( what’s the definition of huge is subjective though), then it makes sense for a 40 stocks portfolio.
We also need to take into account which hat did Prof wear while arriving at this thought? did he carry similar philosophy while he started as an investor?
It is worthwhile to go thru one of the tweet by Sachin Bansal and it has a very deep meaning


I am trying to engage here and should not be taken the other way.

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That’s a good takeaway (perhaps I say that because it aligns with my belief as well…?)

Start with a risk taking attitude when you don’t have much to lose, and many years of earning ahead of you. Grow increasingly paranoid and diversify as your future earning capability decreases, or if you’ve “made it” (to your point on “huge corpus”).

The point is, as in much else, about balance. To search within and seek out where your balance point lies. What are you balancing?

True paranoia and diversification is a never-ending process. Consider this:

  1. You can diversify across companies and sectors. What if the market crashes?
  2. You also include FDs (I don’t like bonds so much), and I’m talking of “safe” FDs like HDFC bank. Remember, you’ve already “made it” so there is no need to take unnecessary risk for a few points of return. But what if your currency fails or your country’s economy collapses (ala Venezuela)?
  3. You diversify in international assets. But what if there is a war in your country, there is rationing (or worse you are trapped like Anne Frank)?
  4. You create a bomb proof basement bunker and hide food and rations in there. See how the diversification can go beyond money? But what if an asteroid hits earth, destroying all life on the planet?
  5. You are Elon Musk, and you look at diversifying across planets (Elon may be driven by other motivations; just saying)
  6. But what if…

At some point, one must put a lid on the paranoia, and move to “acceptance”. Accept that there will always be risks in life, and you cannot diversify away all your risk. The balance point is different for every individual, but it is important to seek it and make your peace with it. At this point, as they say, you can stop worrying and start living.

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Most suggestions/discussions here are time less. I have few questions for current scenarios.

  1. How are you spreading your buys during such downturn - wrt time?
  2. How are you spreading your buys across sectors to protect/grow your investments?

Thank you

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Hi,
Maybe you’ll find the following thread useful as per your queries

Insights into fund manager’s portfolio - copying specific texts

He has allocated 40 per cent of his investment to equity funds, 40 per cent to short-term debt funds, 12 per cent to global funds (mining and energy), 5 per cent to India Value Fund with energy and commodity exposure and 3 per cent in hedge funds.

“Nearly 45 per cent of my investments are in DSP’s Equity Fund and Quant Fund. Very recently, I have added a little bit of natural resources, because if there is hyperinflation going ahead, energy and commodity prices could shoot up. So this could act as a hedge against inflation. These companies are also trading at multi-year lows and have very high dividend yields,” Parekh said

Below write up from Kuvera:

"It is not a bull market until the phrase “concentration builds wealth” starts trending. Since I have read it about 50+ times in the last two weeks on Twitter itself, I am assuming the trend is on :slight_smile:

The quote is attributed to Warren Buffet so carries a lot of weight, and is quickly followed up by examples of Gates and Bezos who never diversified, held majority of their wealth in one stock (Microsoft and Amazon respectively) and are the richest people in the world now.

It is a tempting proposition and given some of the examples of concentrated riches thrown around it entices the new investor. Alas, no one tells the same investors about Exxon employees who had all their retirement savings in the company stock and poof it all went belly up one day. And for that matter the thousands of Lehman employees whose company stock-heavy retirement portfolios did pretty much the same in 2008.

Heck, what about the other Ambani who blew a whopping ~$40 bn in his concentrated portfolio in a decade. Or the most famous of them all, Sir Isaac Newton himself who lost a fortune in the stock of the South Sea Company, an investment that left him broke and led him to refer to speculation as the madness of men.

If you start hunting for real-life outcomes of concentrated portfolios you will find more went broke. Take startups, they are super concentrated portfolios for the founding team and 90% or more startups don’t survive the first five years and a teeny weeny percentage actually becomes unicorns. But unicorns get 99% of media coverage creating the illusion that concentration is good.

We actually have a simple way to measure how concentrated portfolios perform vs diversified portfolios outside of rhetoric or anecdotal examples of one or the other.

Here is what we do, we look at 275 largest stocks in the country over the past 3 years. Then we randomly select three portfolios from it at the beginning of Sep-2017 and hold each portfolio till the end of last month.

  • A super-concentrated 1 Stock portfolio i,e 100% invested in one stock

  • A concentrated 5 Stock portfolio i.e 20% invested in 5 stocks each

  • A moderately diversified 15 Stock portfolio i.e 6.67% invested in 15 stocks each

We then run the experiment over one lakh times to ensure that our outcomes are not dependent on luck of the draw. The chart below shows the distribution of portfolio returns (measured as XIRR) that you would expect to achieve in the three portfolios above.

Let’s look at the super-concentrated 1 stock portfolio first. There is a 19% chance that your 1 stock portfolio returned an XIRR above 16%. But that comes with a risk - a huge 29% chance that your 1 stock portfolio would have returned an XIRR below 16% in the last 3 years. So yes you can make it big, but you can also get bowled out the first pitch.

A moderately diversified 15 stock portfolio, on the other hand, has a low 1% chance of achieving an XIRR of over 16% but also has a negligible almost 0% chance of achieving an XIRR of below 16%.

A more clear picture emerges if you think about the distribution of outcomes of a concentrated portfolio vs a diversified portfolio. The outcome of a concentrated portfolio is bar-belled. A high chance of riches and a high chance of going bust. It’s like the samurai code - you live by the sword and you die by the sword.

I am not sure if this translates to how most traders and brokers frame “concentration builds wealth” as that statement has a certainty to it that the data suggest does not exist at all. With concentration, you are taking a big bet. On average that bet will give outcomes worse than a diversified portfolio - it will clearly destroy wealth. We find that the average 3-year XIRR of a single stock portfolio is -3% while that for a 15 stock portfolio is 1.4%. For an index fund, the same is between 5-7% based on Nifty or Sensex indices.

The data is clear - concentration does not build wealth for the average investor with a concentrated portfolio. But for a few people, who will eventually get monickers like the big bull, that concentration will work and make them wealthy. Are you willing to take the risk of going bust to be one of them? If you answer no, then diversify. And when someone tells you ‘concentration builds wealth’ share this data with them."

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hi, will it be possible to either share the report or the link…its pretty interesting study

@ajay81 what I shared above is the complete report from Kuvera.

Good piece.

There is a belief in the market that success comes from concentration but ideally it should be the opposite - concentration is a function of success. Success is achieved by giving time to a portfolio. Investing time in a diversified portfolio of quality companies would automatically result in ballooning of portfolio with concentration in select holdings.

More than success from concentration, it is important to understand process of concentration. Success will follow. All the best!

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