The above may sound strange. Ofcourse, warren buffett has famously said that large amounts of capital act as an anchor on investment results, but then it is more so for the professional investor and certainly not for individual investors like us.

But I have different viewpoint and it goes like this. For me investing is more of risk than return. Before I look at the likely returns, I tend to look at what I could lose under the worst case scenario. Now the worst case scenario for an individual stock is ofcourse 100%. But it likely that during a market downturn, the portfolio can drop by 25% or more (even for a conservative investor)

It is under these conditions that the portfolio size becomes important. How much is the portfolio as a % of your networth? If it is 20-25 %, I can rationally handle a loss of upto 50%. But if the portfolio is 100% of my networth, I think I would not be rational if the portfolio drops by 50% or more. I could very likely panic and sell at the bottom. Now you may feel that you would not react in that fashion and it is quite likely. But believe me, if you are one of those who started investing seriously in 1998-99 and saw your portfolio go down right upto 2003, you would have wondered when it would end.

Ofcourse looking back at 2003 now, feels like april/ may 2003 (the lowest point of the indian market) was a wonderful time to start investing as the great bull market was ahead of you. But if history was any guide at that time, the market has gone nowhere in the last 10+ years and one had to have the conviction to hold onto and better add to your portfolio at that time (with a negative performance to boot!). It is precisely for this reason that I am conservative in my approach and once I have a few years of experience and have gone through atleast one bear and bull market will I increase my equity portfolio as % of my networth.

So next time when you hear some one brag that he had fanatastic return last year on his portfolio, ask him what % of his networth has he put into equity and has he gone through a bear market with that percentage. If he/she has a high % of networth in the stock market, has had a fanatastic run in the last 2-3 years and is feeling that he/she is the next warren buffett, smile and better, pray for him that he pulls out before the next bear market.

So what if one is levearged and has more than 100% in the market and has seen only the bull market. Unfortunately these are the people who hit the headlines when the market tanks.

Michael J. Mauboussin recently published a paper on the legg mason website called ‘size matters’ on the Kelly criterion and importance of money management.

The paper is slightly technical on probability and an extremely good read. The key point of the paper is that investors should use the kelly criteria of defining the optimum bet size based on the edge or information advantage one has over the market. The formulae is very simple, namely

F = edge/odds

Where F is the percentage of portfolio one should bet. Edge being the expected value of the opportunity and odds being gain expected from the opportunity.

So if one has a meaningful variant perception or edge over the market (translating into a positive expected value) and expects to win big, then the above formulae helps in deciding the size of the bet as a percentage of the portfolio.

In simple terms, if one’s expected value (probability of gain*gain+probability of loss*loss) is high and the gain is also high, then one should bet heavily.

Conceptually I find the above approach very compelling. My own approach has been the similar. For example, if I am confident of a stock (after all the necessary analysis), I tend to allocate a higher amount of money. My definition of low, medium and high is around 2 % , 5% and 10 % of portfolio for a single stock.

Ofcourse the above approach is sub-optimal and would not lead to highest returns over a long period of time. It is not that I have a problem with the formulae. My problem is how do I know that my ‘edge’ is really an edge. Ofcourse whenever I have put money into a stock, the unstated assumption is that I have an edge. but then i invested in tech stocks in 2000 thinking i had an edge. Although I have a quantitative approach of going for a high expected value with a 3:1 odd, I cannot be sure.
So to safeguard myself (against my own ignorance, risk aversion or stupidity or whatever you can call it), I tend to adopt a suboptimal approach which gives me lower returns, but lets me have sound sleep (I have sleep test for risk, if I lose sleep on something, then it is too risky)

But irrespective of how one executes the above concept, it is a very sound one and should be followed to manage risk prudently