How I Think About Capital Allocation Within My Portfolio

I recently had a Supporter ask about how I think about capital allocation within my portfolio, and comment that he wishes he had more capital in high conviction ideas, and cut his losers too early. Now, I can’t offer an answer as to the best way you should manage your portfolio allocations, but I can tell you about what generally works well for me.

First of all, lets deal with the old saying that inspires both the best, and the absolute worst investors I know…

Warren Buffett: “Diversification is a protection against ignorance… it makes very little sense for those who know what they’re doing.”

Now, it’s worth noting here that Warren Buffett’s company, Berkshire Hathaway holds over 50 different stocks in its publicly listed portfolio of companies (and that’s before we even start on the privately owned businesses), according to Guru Focus. So anyone who quotes this at you in order to recommend a small number of holdings falls squarely into the category of person that follows Buffett’s words, but not his actions.

However, I do not deny that the core of what Buffett is saying is correct. Indeed, I will call it Basic Allocation Rule 1.

Claude’s Basic Stock Portfolio Allocation Rule 1

Better ideas deserve bigger positions.

When you have limited capital it makes sense to concentrate it in your very best ideas; the ones with the most favourable risk versus reward but this is only true assuming you are not investing in companies that risk total capital loss.

So let me give you an oversimplified hypothetical example.

Company Stock A has a 75% chance of doubling to $20 and a 25% chance of halving to $5. So its current price is $10, you’d say its probabilistically weighted value is $16.25.

Company Stock B has a 95% chance of going to zero, and a 5% chance of increasing 49x to $500, from its current price of $10. Based on these probabilities, you might argue correctly that its value is around $25, and so it’s more undervalued than Stock A… thus deserving a bigger position according to Basic Rule 1.

Of course, this is where Basic Rule 1 falls down, especially in a concentrated portfolio. If you had 8 stocks in a concentrated portfolio, and they all look like Company Stock B, you are leaving an awful lot in the hands of fate. It is quite possible you will have your entire portfolio go to zero!

So that leads me to:

Claude’s Basic Stock Portfolio Allocation Rule 2

Companies that have a significant chance of going close to zero are de facto trash and are never “good” ideas, no matter how good the “probability weighted outcome” is.

Now that we’ve dealt with those first two basic rules I follow, here is how I think of my portfolio (approximately).

A Team

Core stocks are growing companies that have trustworthy aligned management, and already have profits, or could without doubt be profitable easily if they slowed growth. These are at least 50% of my portfolio. You can’t get high personal conviction in a company without following its story for a few years, even if someone you trust loves the stock, so it’s hard to find new A Team stocks. You can’t find your A Team without watching a few seasons.

A Team stocks are slow to go easy to add.

B Team

The entire point of the portfolio is to populate the core A Group with the best stocks, but this will involve investing in earlier stage companies that aren’t yet profitable or ideas you feel less confident in. After all, you can’t gain confidence on a stock until you have followed it a while. These future core stocks, the B Team, can still be decent sized holdings, and often are ideal to add to as they improve as businesses, if they are still under the radar, but I’m a lot more inclined to take profits or cut them out if things are not going well.

B Team stocks are medium to go, medium to add.

C Team

Of course, most people that are interested in the micro-cap end of the ASX (or even growth stocks) fancy themselves to have enough intelligence and judgement to get ahead of trends, spot promising businesses no-one really rates yet, and understand novel businesses that have potential to gain traction. These riskier “C team” stocks are often high risk and may include a foreseeable scenario where they go to zero. In other words, they might be trash! That means I’ll need to dump them if the evidence points to a significant likelihood that they are indeed trash.

C Team Stocks are slow to add, and easy to toss.

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This post is not financial advice, it may not apply to your situation at all, and you should click here to read our detailed disclaimer.