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Hello Dear Reader,
Today I want to talk to you about portfolio allocation and bet-sizing.
Before we dive into it, I want to tell you a story.
Imagine that you are walking down the road and you see a magic lamp. You pick it up and rub the lamp. A genie appears.
The Genie gives you three options.
I will double your money in 13.5 years for you, risk free.
I will double your money for you in 9.73 years, at moderately low risk.
I will double your money for you in 4.8 years, taking less risk than most people do.
Now, as optimistic and as trusting a person as I am, I would choose Option 3. I am sure many would not choose Option 3 and that is ok. I placed a small amount of my positions, say 2% with this Genie as even an optimistic and trusting guy like me knows what he is saying is too good to be true. I then sit quietly for 5 years.
As time passes by I forget that I met a Genie on the road and I put 2% of my positions with him. 5 years later I get a knock on the door. I open it and its the Genie. He is returning me my initial corpus plus what he promised. He then starts to leave. I am surprised, amazed, shocked, clueless and saddened all at the same time. I feel I should have trusted the Genie and made a bigger bet allocating a higher percentage of my positions to his conviction. But I cannot change the past. I can only make the future better. I quickly chase after him, stop him in his tracks and give the Genie whatever amount he handed me over earlier. The Genie smiles and leaves. A few days after he leaves, I feel I have made a big mistake. I quickly call the Genie and ask my amount back. He gladly gives it back. I forget about the whole incident.
5 more years pass. I am at the park with my family. I run into the Genie. The Genie is talking to a mysterious person. I go over to say Hi to the Genie. As I approach the Genie, I hear what the mysterious person he is saying, “I am so lucky that I met you and gave you 60% of my savings 10 years ago. Now, I can finally take risks in life.”
I get intrigued and before greeting the Genie ask this mysterious person what he is talking about. The mysterious person tells me that 10 years ago, he found a lamp on the side of the road. The Genie appeared. The Genie told him that he could double that person’s money in 4.8 years. The person took a big risk on the Genie’s word of mouth and gave him 60% of his savings. Today, 10 years down the line, the person has made a 4x return on his investment.
I was surprised, amazed, shocked, clueless and saddened all at the same time.
I bid farewell to this mysterious person and left.
Now, back to today. Our topic of discussion is portfolio allocation and bet-sizing.
I am not aware of the exact number, but some reports say there are more than 4000 companies listed on the BSE. An average portfolio of a retail investor has not less than 30-40 companies. Most retail investors divide their portfolio into Core and Satellite. They keep 15-20 stable companies in their core portfolio and 7-10 cyclical, event based bets in their satellite portfolio. Sometimes, the satellite portfolio allocation becomes more than the core. This newsletter is not about that.
I want to teach or rather advocate to a strategy, using which everyone can have at max 10 companies in their portfolio over the course of their investment journey. For this purpose, we will assume that the Genie that we talked about in our story actually exists.
This brings us to a very interesting rule. The Rule of 100. The Rule of 100 says that 100- your age now is the amount you should invest in Equity. Now, for the sake of argument, we will assume that the Genie is mix of low cost Index ETFs. This mystery person was 40 years old when he met the Genie. The mystery man knew about the Rule of 100. In my maiden newsletter titled Developing Mindset, I had mentioned how one could make 16.5% on a yearly basis doing an equal weight investment in 4 ETFs as double your money every ~5 years taking moderately low risks. We will also assume this mystery man had read my maiden newsletter.
What I did not mention in my First Newsletter was how passive investing can actually help one become an aggressive concentrated investor in direct equities. Maybe the mystery person figured this out on his own.
When fishermen cannot go to sea, they repair nets.
-Nabil Sabio Azadi
Imagine yourself in the shoes of a fisherman who is not going to go-to sea anytime soon. You have a good 5 years to do the following tasks:
Find your circle of competence
Know about most of the listed players in your circle of competence domestically and globally
Try to expand your circle of competence
There are various ways in which one can expand his/her circle of competence. But reading is perhaps the best way to start.
I try to read 2 annual reports per week and try to complete 1 book per month. This may seem like a lot but this is nothing compared to investors who read on an average 2 ARs a day. I understood it very late in life that they are not trying to find opportunities to invest but rather businesses that they understand. Their main focus is on increasing their circle of competence. Now, I think of myself as a fisherman who has to just repair his net for the next 5 years. I have this luxury as like the mystery man, I am following the Rule of 100 and the Rule of 72 (First Newsletter) and have switched over to passive investing.
In the next 5 years, I am going to ask myself the following questions:
Am I optimistic about the economy for the next 20 years going forward?
Do I know how market cycles work in the companies are are within my circle of competence?
Have I developed the right mindset? If not, will I be able to develop it in 5 years?
Do I feel that I know most things about the companies in my circle of competence?
Have I developed my own stock selection process or is it borrowed/copied/stolen from someone?
Am I flexible or do I have a fixed mindset about sectors, stocks, business houses?
How complicated or how simple will my investment thesis be going forward?
Have I read just for the purpose of reading or things that have changed me as a person and as an investor?
And most importantly, can I beat the performance of the Genie (Low Cost ETFs) on a 5 year basis going forward investing in companies in my circle of competence? If I can, do I have the courage to back up the truck and increase my bet size and portfolio allocation?
We will take three cases here:
This is after I have a time of minimum 5 years to plan concentrated bets, withdraw 25% of my portfolio in year 5 when my absolute returns hit 1x and then finally make these bets backing up the truck. The best part is that even if my conviction and judgement turn out to be wrong, I make more than most investors and what I would have in an FD.
Now as I end this newsletter, I will take Case II and leave you with a set of questions.
You have a Genie who is doubling your initial corpus every 5 years. You have figured out after 5 years of hard work a way to beat him at his own game. Will you still use the services of this Genie?
If you won’t be using the Genie’s services, what is your reasoning?
If you will still use the Genie’s services, what is your reasoning?
I will give my answer to these questions in the next Newsletter. Till then, keep safe and invest wisely. This newsletter was to tell you all about portfolio allocation and bet-sizing and how you can you can increase your average bet size while making a concentrated portfolio. I hope the newsletter served its purpose. Do subscribe and recommend it to your friends it you liked what you read.
For any queries or feedback, do get in touch with me on email@example.com
Disclaimer: The author of this publication is not a SEBI Registered Advisor or Analyst. The information on the company and its promotor mentioned in this newsletter is provided for information purposes only. It does not constitute an offer, recommendation, or any investment advice to any person nor does it constitute any prediction of likely future movements in the company’s stock prices or business performance. It should not be used as a basis for any investment decisions or as a proposition to buy or sell any securities. Please seek advice from a registered financial advisor and do your own due diligence before making any investment decisions.