Towards a Capital Allocation Framework!

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 ?

1 Like

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.

18 Likes

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.

5 Likes

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.

3 Likes

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.

1 Like

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.

10 Likes

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.

7 Likes

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

1 Like

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."

16 Likes

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!

1 Like

Prof. Sanjay Bakshi’s presentation on ergodicity is very relevant to the topic

1 Like

Great discussion.
I have question related portfolio allocations. I thought of creating different thread, but found this thread.

Problem Definition-
Suppose I have cash, but I do not see an opportunity to invest.

  • Shall I wait for the opportunity and remain in cash or keep fully invested.?

    Example: Suppose I have Rs 100 of the portfolio. I have invested 70 of it in different stock. Additionally, at any point, I want to have cash of 10 available to deal with any unforeseen situation, including buying additional stock in case of a sharp correction. This leaves cash of Rs 20 with me.

    I am really keen to invest in 20, but the current market does not offer me the opportunity. My below question, how should I utilise 20?.

After debating the above question, I thought the following two strategies make sense. Here are my points for both the strategies.

Options 1:

  • Keep fully invested or all most fully invested. (e.g Invest Rs 20, out of 100- all/most of the time)
    Here you have already invested (e.g 70) with companies you have conviction, and you do not wish to increase the exposure to existing holding for n-number reasons.
  • So essentially you are seeking new investment, but you are not finding investable opportunities.

Decide on an amount which you would want to preserve e.g 20

  1. Invest in a solid business which can withstand major corrections.
    Example- HDFC, Bajaj Finance, ITC, Asian Paints

Stock Selection Criteria

  • Strong downside protection. The probability of going lower is very less.

  • Downside protection is the most important criteria.

  • The stocks shall be from different sectors.

  • Shall not correct heavily.

  • Stocks shall not co-related.

  • Spread investment across a set of stocks (e.g two-three stocks or more)

  • The stock shall not come from a sector which is attracting lots of attention at the moment (e.g Pharma or Chemical sector as on today).

Advantage

  • You are invested the market all the time.
  • You are able to participate in the higher market (which is most of the time over the long term).
  • As you are not buying a hot sector or hot, you are investing in a comparatively safer stock.
  • In theory, if you take longer to find a stock, you can still in the market and avoid Fear of missing out (FOMO).

Disadvantage/Additional thoughts

  • One may ask - The stock may correct when you need the money to invest in your high conviction idea the most?
    Rational - If the overall market goes down, the key stock will also go down. However, if HDFC/Asian Paint falls by 10%, it is likely that stock in the other sector may fall even more. So in a sense, your stock has fallen less. In case you want to buy other investments, it is relatively better than before.
  • Example. Assume HDFC is 2800 today and Piramal is at 1700 (12 Feb 2021). Today each HDFC will give you 1.65 Piramal Enterprise (PEL). If the market correct (take an example of Covid) HDFC corrected to 1500, but PEL corrected to 700. So at the bottom of extreme pessimism, one HDFC was giving 2.1 PEL shares.
  • You are always invested.

I remember Bill Ackman mention this in one of his interviews. However, I cannot find a source now.

Option 2- Wait for an opportunity to invest.

  • Wait for the opportunity.
  • Invest as if you are investing for the long term.
  • Keep in cash until you find opportunity (20 in cash)

Pro

  • Money is ready to invest when the opportunity is presented.
  • Do not have to rely on selling other stock before buying new stocks.

Con:

  • When faced with the situation I keep looking for a market correction. It is a shallow correction (5 to 20%) you invest in stocks. However, if the deep correction (e.g 2008 like or Covid) correction, emotions does not allow to invest.
  • I keep looking for factors that can drive the market down. When faced with this kind of situation, I drifted towards listening/hearing people who are sceptical about the market going high. Being sceptical is good, but there is some expert who is pessimistic most of the time. I have observed that e listening to an economist is interesting but takes up a considerable amount of time, which I could have utilised for much better use.

Additionally, in such situations, I tend to remind myself of Warren Buffet, and Charlie Munger advise.

Forming macro opinions or listening to the macro or market predictions of others is a waste of time. Indeed, it is dangerous because it may blur your vision of the facts that are truly important.

Additionally, when asked (to Warren & Charley) how much time they spent in a year listening to macro forecast, they answer something in the line of 90 seconds in a year.

Overall, I have a been in the second camp, waiting for the opportunity to be available before deploying cash. However, I am challenging myself if that was the right strategy? Are they are any better strategy?

When I hear Ramdeo Agarwaral or Rakesh J they always say they are fully invested. No doubt they are in different league , but being fully invested could be a good advise for individual investor too.

What is community experience and how do they tackle similar situation?
Any comments/views/suggestions welcome.

2 Likes

I used to overthink this a lot. While we all have to find our own right answer, I hope this helps:

This is a view I subscribe to and follow.

""Temporary” in temporary parking place could last as much as 5 years. Do no fret
over poor nominal returns you get from fixed income investments and negative real
returns after counting inflation during those long years. The purpose of this money is
not to make money. The purpose of this money is to be available when a fantastic
opportunity arise"

Also,

The world is a shade of grey. Many a time most debates are reduced to black and white opinions - diversification Vs concentration, high quality Vs unproven quality, buy and hold Vs momentum based churning.

Anyone not in a position where one has to stick to a stand and build reputation/business based on that approach has an inherent advantage. Why not go with a hybrid model? Problem is that we are told by media/gurus to find one philosophy and stick with it. Once again this is a narrative that we don’t need to fall for as retail/non-professional investors.

What do I mean? My portfolio has concentration and diversification at the same time. 20% of my net worth in one stock but 40% allocation to fixed income and the remaining 40% spread across 15-20 well researched stocks. Not easy to slot this into a specific narrative but who cares, it works well for me.

Some people aren’t comfortable with volatility by nature, concentration doesn’t work for them unless they have some operational control on the business too. Speak to promoters who have 70% of their net worth in their own listed business, they don’t see that exposure as equity since they have operational control. The same Jeff Bezos would have a different allocation pattern if he weren’t running the show at Amazon.

Capital allocation should ideally be a function of who you are and how you see money. Those who are already wealthy often trade alpha for peace of mind, the incremental 4-5% return does not move the needle for them. But those who have aspirations of doubling their net worth every 3 years will try to squeeze out every additional 1% at every opportunity and also have a high equity allocation.

Over the past 6 months I have allocated more to FD than to equity, but that is an outcome of my personal utility function that seeks to balance out my life. I have both investment income and operating income dependent on how the market performs, the world looks different to me though I’ve always had 60%+ in equities over the past 5 years (March 2020 included).

A general rule that works well is that higher your alpha generation capability, lesser can be your equity allocation. If all you do are index funds/ETF that can deliver 12-14% over the medium term, you will most likely need higher equity allocation to create wealth. However if you can generate a return of 25%+ through stock picking, 50% might suffice during most times. When the bottom falls off the market, you can allocate more money and make more return than someone who is sitting at 60% equity allocation.

The average user on this forum should think deeper and not go by the superficial gyan peddled by media. Media likes to simplify the message so that even a dart throwing monkey can take away a few basic rules. The average user here is way smarter than that.

Wealth management is still in the primitive stage in India, building asset allocation models is reduced to a few things like -

Age of the person
Allocation to equity, fixed income, real estate and gold
Liability and event/goal based planning

The most important variable (behavioral and attitudinal profile of the person towards money) cannot be quantified, this can only be evaluated through a comprehensive exercise by a wealth manager who has both the IQ and the experience to be able to do so. The average age of the wealth manager in India is 35 years and they have less than 20% of their own money invested in equities. Go figure how much of an advisor he/she can be. Some successful wealth managers are exceptionally dumb people, they can talk their way out of anything but cannot make sense of financial statements.

The primary goal of any capital allocation framework should be that you always live to fight another day even if the market falls 50% and stays there for 3 years. Once this is ensured the rest of the steps become subjective based on a variety of factors. 40% allocation to fixed income works differently at a net worth of 10 Cr than it does at a net worth of 50 lakh.

54 Likes

Brilliant Post…Just few queries…
In case of 40% Fixed Income allocation, what are your favourite Fixed Income Products?
also what are your views about Commercial Real Estate investment as a alternate Income Generation avenue? Can it be considered good to hedge your anticipated 50% fall in markets? Kindly Guide.

2 Likes