This One Factor Can Increase Your Gains from 2x to 10x

There are two critical elements of making money in the stocks markets.

The first is stock selection. It's also the most in focus.

The way markets have run up, there're an army of experts offering stock tips. Twitter, investing blogs, and chats are breeding grounds for this.

The common investor is becoming a victim to stock ideas distributed freely. The promise is big, and rationale, sketchy, if at all.

I'm sure many of you would have doubled or tripled your stock investments over last one year. To preserve them, be very cautious on who you take advice from.

Understand the businesses you are investing in and keep tracking the execution. If you choose well, chances are you will hold on to the gains even if markets fall in the short term.

But even a good stock selection will not help you make a big difference to your gains, if you miss out on the second factor.

I'm speaking of the bet size or allocation.

A few years ago, I read a famous book that dwells on this aspect - Concentrated Investing: Strategies of the World's Greatest Concentrated Value Investors.

The book shares an interesting analysis by Elton and Gruber. It quantifies the impact of the number of stocks on the risk in a portfolio.

The risk here is a deviation of portfolio return from market return. As such, the portfolio with a single stock has maximum risk. In the same way, a portfolio with all listed and traded securities has zero risk.

Now one invests in equities not to minimise risk. For that, fixed deposits are a better option. The aim is to maximise returns, while keeping risks in check.

Here's the most interesting outcome of this analysis:

Most of the gains from diversification (i.e. reduction in risk) are enjoyed by holding 20 to 30 securities.

But let's take this a step further.

You see, 20 to 30 holdings in a portfolio is fine from risk minimisation perspective.

But that might not help you achieve the Holy Grail of early retirement.

It makes sense to begin with an equal-weighted approach. But overtime, you will realise a certain set of businesses are better in terms of growth opportunity and execution.

As your conviction in the management grows, it's okay to go for a higher allocation.

Some of the world's best investors swear by it.

And if not for this second factor, chances are they would have never made it big.

Consider Warren Buffett who said...

• 'I can't be involved in 50 or 75 things. That's a Noah's Ark way of investing - you end up with a zoo that way. I like to put meaningful amounts of money in a few things'.

If you look at Berkshire Hathaway's holdings, 40% of it is allocated to a single stock. Apple Inc. makes up around 40% of equity portfolio. It's up from 6% in 2016.

Even when Buffett used to manage much less capital, five stocks comprised 90% of his portfolio.

Now I don't recommend your portfolio be so concentrated, unless you know the businesses and the managements really well and are fine with the risk it entails.

That said, beyond a certain point, healthy diversification becomes diworsification. It's critical to be mindful of this.

This is what the famous economist John Maynard Keynes has to say in the matter:

• 'As time goes on, I get more and more convinced that the right method in investment is to put large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.
  
  It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.
  
  One's knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.'

Now once you have a high conviction on the management and business, how much should you invest?

Some research into this aspect might lead you to Kelly's formula, the guiding formula for the size of the bet). Here's what is says...

Size of the Bet = Edge or Expected Outcome / Odds (Total amount for a positive result)= ∑ (Odds x Probability) / Odds (Total amount for a positive result)

While this is quite popular among big investors, I would advise discretion.

To understand this better, let's take a hypothetical case, Paytm.

Let's say you applied for Paytm IPO with hope of 80% listing gains (assuming it will do a 'Nykaa'). Offer Price: Rs 2,150.

You expect a 50% chance it will list at 80% gains. However, you like to work with caution.

So you also believe that there is 30% chance it will list with no loss no gains, and a 20% chance it might list at a 45% loss.

Expected Outcomes Under Different Scenarios

Cases	Probability (A)	Odds (B)	Expected Outcome (AXB)
Paytm Lists at 80% Gains	50%	1075	537.5
Paytm lists at no gains no losses	30%	0	0
Paytm lists with 40% loss	20%	-860	-172
Total Expected Outcome			366

Source: Equitymaster

As per the formula, Allocation = Sum of Expected Outcomes/ Amount for a positive return

=366/1075

=34%

As we can see with the benefit of hindsight, operating in the real word with this formula could be tricky.

The world doesn't move in line with probabilities we assume. And a deviation could turn the assumptions upside down.

This is why you should be mindful of the limitations of any formula-based guidelines while investing.

Nonetheless, it will make sense to increase allocation in businesses that continue to perform if you see a strong case of growth and expansion in return on capital. Don't remain anchored to your original entry level.

We did that with our 'crorepati stock'.

While we started with standard allocation guidelines, we were impressed with the new opportunities it was getting into. Our confidence in the management grew overtime as they kept executing.

We did not hesitate to increase allocation at levels higher than the original target price. We have been handsomely rewarded for that.

To conclude, big gains in stock market don't just come with right stock selection. The right bet size is critical.

You can only do this well if you understand the business and the management you are investing on.

Bottomline: To have extra ordinary gains and concentrated investing approach, you must know the business and managements well.

If you also get the selection right, you can beat markets significantly. A wrong selection, however, will be a death knell for your portfolio returns.

Warm regards,


Richa Agarwal
Editor and Research Analyst, Hidden Treasure