In part 1 of this series I presented the case for focus investing. That is for concentrating your portfolio on your top ideas. Now let's look at what size each of our investments should be.
Position sizing
OK, let's say you're convinced that focus investing is the way to go, and you've found a stock about which you're trembling with greed. What percent of your assets should you invest in it? 2%? 20%? (Or, given the cheap, easy leverage these days, 200%?) The answer depends on a number of factors such as your tolerance for volatility, the expected upside, and the potential downside. Generally speaking, an ideal value portfolio would have 12-20 well-diversified 50-cent dollars (e.g., stocks trading at half of my conservative estimate of their intrinsic value), of which roughly five were 10% positions and rest were 5-9% positions.
I did not pick this range of 12-20 stocks arbitrarily. In Joel Greenblatt's brilliant book, You Can Be a Stock Market Genius, he provides the following statistics (see pages 20-21):
- Owning two stocks eliminates 46% of nonmarket risk of just owning one stock
- Four stocks eliminates 72% of the risk
- Eight stocks eliminates 81% of the risk
- 16 stocks eliminates 93% of the risk
- 32 stocks eliminates 96% of the risk
- 500 stocks eliminates 99% of the risk
The following chart demonstrates this point graphically. As the chart shows, most of the benefits of diversification are gained once 20 – 30 stocks are owned.
Once one has a well-diversified, balanced portfolio of a dozen or so stocks, adding additional stocks does little to reduce risk, yet there's obviously a big penalty in terms of performance if one's best ideas are 3-5% positions instead of 7-10% positions.
Keep in mind, however, that there is no right answer. I know many fantastic money managers who own a few dozen stocks and some who own only a half dozen, but 12-20 is the level at which I'm comfortable. You need to find your own comfort zone.
At one point in my investing career, I (Whitney Tilson) invested in a more concentrated fashion — for example, I doubled my Berkshire Hathaway holdings to an 18% position on March 10, 2000, a day I remember well because it was the last spasm of forced selling of the stock, driven by investors piling into tech stocks (it was the very day that the Nasdaq peaked at 5,032 — a level that, mark my words, we will not see for at least another 10 years).
While that investment worked out well (I still own some of the Berkshire stock), I'd be surprised if I ever again invested so much of my portfolio in one stock. Why? Let me show you the scars on my back and tell you some stories. Just in the past two years — two very good years, incidentally — I've had a 10% position decline by 30%, two 7% positions lose two-thirds of their value (all three subsequently recovered), and a 2% position go bankrupt (I bought at $6 and sold at a penny — ouch!). As a result, I've learned that no matter how much confidence I have in an investment, the future is inherently unpredictable and all sorts of unexpected calamities can occur. I still practice focus investing, but thanks to Mr. Market teaching me some humility, I'm not quite as focused as I used to be.
In part 3 of this series we'll look at sizing common stocks, shorts, options and speculation. Focus Investing – Part 3.
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More articles on portfolio management:
- Focus Investing – Part 1
- Diversification without diworsification
- Two great investors sharing one winning strategy
A version of this article was originally written by Whitney Tilson for fool.com.
