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Focused Investing: The Power of Allocation in Wealth Creation

Opportunities for big bets come seldom; Focused Investing is a sound strategy to capitalize on them.

  • First study on how much to buy: Two key aspects of equity investing are: (1) What to buy (i.e. stock selection), and (2) How much to buy (i.e. stock allocation or weightage in a given portfolio). The first 20 Annual Wealth Creation Studies covered various aspects of what to buy. The 21st Study focuses on how much to buy.
  • Kelly’s formula – insights for equity investing: In the mid-1950s, John Larry Kelly Jr, a scientist with Bell Labs, developed a formula for optimal bet size on a wager with given payoffs (i.e. odds) and win-loss probabilities. The formula is as under:

    f = (bp – q) ÷ b

    where:

    f is the fraction of the current bankroll to wager, b is the net odds (expressed as rupees to be won for every rupee bet) or win-loss ratio, p is the probability of winning, and q is the probability of losing.

    The above formula was developed for gambling, and its mathematical relevance is not very high in equities. Yet, it offers meaningful insights for equity investing:

    1. Look for asymmetric payoff i.e. high-upside, lowdownside
    2. Create edge over the rest of the market i.e. information advantage and analytical advantage
    3. Bet big when #1 and #2 coincide.
  • What is Focused Investing: There are two contrasting investing styles around the riskreturn tradeoff:
    1. Diversified investing: The underlying strategy in diversified investing is to hold a fairly large number of stocks (50+) across sectors so that unexpected adversity in any stock or sector does not unduly hurt overall portfolio performance. However, this typically leads to modest returns
    2. Concentrated investing: Concentrated Investing essentially involves choosing a handful of stocks (typically not more than 10) that are expected to produce above-average returns. This strategy leads to volatility in performance, and maybe less suited to manage public money.

    Focused Investing is the golden mean of the above two investment styles. Compared to 50+ stocks under Diversified Investing and 10 or fewer stocks under Concentrated Investing, a focused portfolio of 15-20 stocks offers the best of both worlds - adequate risk diversification and meaningful return magnification.

  • Four keys to successful Focused Investing: These are: (1) Clear portfolio goal (2) Superior stock selection (3) Rational allocation and (4) Active monitoring & improvement.
    1. Clear portfolio goal: A simple, clear and measurable portfolio goal serves as a useful guidepost for both stock selection and stock allocation.
    2. Superior stock selection: Stock selection is critical, and hence investors are better off using a time-tested investment philosophy / process of stock selection.
    3. Rational allocation: The study suggests the allocation framework of ConfidenceAdjusted Payoff (CAP) as under:
      • Rank all the selected stocks in descending order of their expected 3 or 5-year upside.
      • To this upside, apply a Confidence factor range from 0 to 100%. The main idea behind the Confidence factor is to deflate the expected upside for risks that may not have been explicitly captured in the upside calculations.
      • For each stock, arrive at Confidence-Adjusted Payoff (CAP) i.e. Upside x Confidence factor.
      • Rank the stocks in descending order of CAP, and align the final allocation.
    4. Active monitoring & improvement: This is very important, as odds on stocks change frequently due to change in underlying fundamentals, or stock price, or both.

    Disciplined practice of the above four steps should lead to exceptional returns rather than acceptable returns.

How allocation influences portfolio performance

  • The simplistic example of a hypothetical portfolio presented here shows how stock allocation can significantly influence investment performance. For the same set of stocks, 3 portfolios with different allocations turn in total return ranging from as low as -8.5% to as high as +18.5%.
Stock Stock Return Allocation Portfolio-level Return
Portfolio A Portfolio B Portfolio C Portfolio A Portfolio B Portfolio C
Stock 1 50% 10% 20% 5% 5.0% 10.0% 2.5%
Stock 2 40% 10% 15% 5% 4.0% 6.0% 2.0%
Stock 3 30% 10% 15% 5% 3.0% 4.5% 1.5%
Stock 4 20% 10% 10% 5% 2.0% 2.0% 1.0%
Stock 5 10% 10% 10% 10% 1.0% 1.0% 1.0%
Stock 6 0% 10% 10% 10% 0.0% 0.0% 0.0%
Stock 7 -10% 10% 5% 10% -1.0% -0.5% -1.0%
Stock 8 -20% 10% 5% 15% -2.0% -1.0% -3.0%
Stock 9 -30% 10% 5% 15% -3.0% -1.5% -4.5%
Stock 10 -40% 10% 5% 20% -4.0% -2.0% -8.0%
Portfolio Total 100% 100% 100% 5.0% 18.5% -8.5%

Superior stock selection framework

  • The 21st Wealth Creation Study’s theme is stock allocation. However, stock selection precedes stock allocation. The study suggests QGLP as a superior stock selection framework.