In part 1 of this series I presented the case for focus investing. In part 2 I discussed the number and size of positions to hold in your portfolio. Now let’s look at sizing common stocks, shorts, options and speculation. Sizing common stocks I (Whitney Tilson) typically will not add a common stock position to my portfolio unless I’m willing to make it a 5% position. If I don’t feel confident enough to invest at least this much, that’s a good signal I shouldn’t own it at all. Once this initial position is established, I cross my fingers and hope that the stock goes…down….
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In part 1 of this series I presented the case for focus investing. In part 2 I discussed the number and size of positions to hold in your portfolio. Now let’s look at sizing common stocks, shorts, options and speculation.
Sizing common stocks
I (Whitney Tilson) typically will not add a common stock position to my portfolio unless I’m willing to make it a 5% position. If I don’t feel confident enough to invest at least this much, that’s a good signal I shouldn’t own it at all. Once this initial position is established, I cross my fingers and hope that the stock goes…down. Yup, you read that right, down! Why? Because I want to buy more and make it a 10% position, but need a bigger margin of safety to do so.
Let me give you an example of a dream scenario. At the end of 2002, the worst year in the fast food industry in 20 years thanks to a weak economy and a burger war between McDonald’s (NYSE: MCD) and Burger King, McDonald’s stock hit a multiyear low in the $16 range. I believed that, despite horrible mismanagement, McDonald’s remained one of the world’s great businesses and that the new CEO had a sound turnaround plan. My estimate of intrinsic value was in the mid-$20 range, so at $16, I felt that I was buying with a 40% margin of safety — enough to make the stock a 5% position.
Then I got lucky: McDonald’s continued to report weak results and investors became very bearish on consumer spending as the Iraq war loomed, so the stock fell to a 10-year low of just above $12 in March 2003. At the same time, I interviewed a long-time McDonald’s franchisee who gave me insights into the dramatic positive changes that were occurring within the company but whose impact was not yet visible in the numbers. Thus, while the stock I had purchased initially was down 25% in only a few months, I had even more confidence in my investment thesis and was thrilled to be able to buy the stock at an even lower price, so I backed up the truck and doubled the position (which I still own).
The following chart highlights the different effect 3% and 10% positions have on portfolio returns. Taking 3% bets on your best ideas dramatically reduces their benefit and the value of you research, whereas blowups on a 10% position don’t hit your portfolio much more than if it was a 3% position.
Though I do some shorting, it’s an awful business for many reasons, one of which is that one shouldn’t do it in size, as losses are potentially unlimited. If a stock is a 7% long position at $15 and drops to $5, it will cost you nearly five points of return, but it won’t put you out of business, you aren’t forced to sell at the bottom, and — if you have real guts and conviction — you can buy more.
But what about a 7% short position at $5 that jumps to $15? That costs you 14 percentage points of return and you may be forced to cover to prevent further losses, even if you have more confidence in the position. Thus, you can see why I rarely make a short position larger than 2-3% and prefer a basket of even smaller positions.
Given the implicit leverage of options, I tend to make them small positions — generally 0.5%-2.5%, though it’s hard to share any rules of thumb since some long-dated, deep-in-the-money options are very similar to the underlying stock, while short-dated, out-of-the-money options are highly speculative.
One might ask why a conservative value investor like myself would ever invest in something highly speculative, but I’m willing to make such investments with a small portion of my portfolio as long as I’m confident that the expected value is much higher than the price I’m paying. Consider an investment with the following expected one-year payoffs:
- Loss of entire investment: 60% chance
- No gain or loss: 10% chance
- 2x gain: 10% chance
- 5x gain: 10% chance
- 10x gain: 10% chance
The expected value of a $1 investment given these probabilities is $1.80, a fabulous return, but let’s assume you could only make this investment once. Would you do so, knowing that there’s a 60% chance that you’d lose it all? Try explaining that to your investors (or worse yet, your spouse)!
If you did make the investment, how much of your portfolio would you risk? This is not a hypothetical question; in the past few weeks, I faced a very similar choice and chose to invest 2% of my portfolio.
While there’s little doubt that focus investing is likely to yield the highest long-term returns, there are no hard and fast rules about how concentrated one’s portfolio should be — it depends on tolerance for volatility, availability of other investment options, the confidence in one’s analysis, and many other factors.
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More articles on portfolio management:
- Focus Investing – Part 1
- Focus Investing – Part 2
- Diversification without diworsification
- Two great investors sharing one winning strategy
A version of this article was originally written by Whitney Tilson for fool.com .