Position Management

Position Sizing at the Portfolio Level: Capital Allocation

December 26, 2012

Coins on a table

Traditional diversification advice dictates that individuals should own a wide variety of investments in their portfolio including a portion allocated to income vehicles such as bonds, a cash / money market position, and a minimum of 20 stocks. This post isn’t going to focus so much on the macro-level strategy of bonds/cash/stock, but will look at the number of stocks and ways in which capital can be allocated to them as a value investor.

There are two primary reasons to ensure a portfolio has adequate diversification. First, if any one company has a catastrophic event, we don’t want it to have a devastating effect on the investor’s entire portfolio. A 50% drop in a company’s stock makes a much bigger impact if it’s part of an equally balanced portfolio of 5 stocks, compared to another portfolio that holds 20. Secondly, various industries are cyclical in terms of their growth and by choosing to invest in companies from a wide range of different industries, it can serve to smooth our the ups and downs in an investor’s portfolio. Does it make sense to follow traditional diversification advice as a pure value investor? Let’s have a look.

What do the Big Guys do?

We’ll start by looking at some of the portfolios of some of the most famous and highly regarded value investors, starting of course with Warren Buffett’s Berkshire Hathaway. Mr. Buffett’s company regularly reports its US investment holdings, and as of September 30, 2012 it held a total of 39 US companies. At first glance, it would seem that he is a big believer in highly diversified portfolios. Something to keep in mind however, is that the US portion of Berkshire Hathaway’s portfolio is currently valued at $74.5 billion! With that kind of money, it’s virtually impossible to be anything but highly diversified since individual investments in the billions of dollars have a material effect on individual stocks. Upon closer inspection however, you will see that over $57.7 billion are invested in just 6 companies, or over 77% of the portfolio! In fact, Buffett has on several occasions made the case against owning stock in too many companies, as his belief are that it is best to be focused on the investments with a high expected return only, of which there are not always a lot to choose from.

George Soros, another prominent investor with a track record of huge compounded investment returns, is the founder of Soros Fund Management and has achieved compounded annual returns in excess of 20% over four decades. According to the great book, “The Winning Investment Habits of Warren Buffett & George Soros” by Mark Tier, Soros follows the same philosophy as Buffett and tends to shun traditional diversification advice as well.

Capital Allocation for the Individual Investor

Due to the stringent nature of the value investment strategies I employ, there are usually only ever a handful of companies that meet my investment criteria at any given time. Even if I wanted to diversify heavily, I would end up buying stock in companies that don’t necessarily align to me targets and objectives. I therefore aim to hold between 7 and 10 companies in my investment portfolio.

Along the same thinking lines as above, I do not mind sitting in cash until appropriate opportunities are available. Yes, this can lower overall portfolio returns in the near term, but long term I would rather be earning a small amount of interest on my cash, than potentially losing money by investing just for the sake of having all of my capital working for me.

I also aim to allocate equal capital between each holding, for example 10% spread between each of ten companies, or about 14% spread between seven. It never works out to be a perfectly symmetrical allocation, but it’s what I aim for. Occasionally there may be a stock that I wish to invest in that I deem to be a high risk/reward opportunity. In this case I may opt to only allocate a small portion of the portfolio towards it, usually less than 5%. Typically I do not rebalance the portfolio as stock prices grow/decline. I prefer to let the stocks that are doing well run until my predefined exit criteria is met.

Some of my position entry strategies are based on scaling into the overall position. In these cases I always define up front the total amount of capital that I want to allocate to the individual security, and it’s based on a percentage of my overall portfolio size. For example, if my overall portfolio size was $300,000, I may determine that I wish to allocate 10%, or $30,000 in a new addition to the portfolio. I decide this up front, despite the fact that my actual entry into the position might consist of three $10,000 trades over a period of several months.


In summary, following are the capital allocation rules that I have defined for myself. Yours will differ depending on your own circumstances.

  1. Level of diversification depends on the number of good investment opportunities available, but aim to own a portfolio of 7 – 10 companies.
  2. Define total capital allocation up front, prior to initiating a new position.
  3. Equal initial capital allocation between all holdings, for example 10-15% of total capital for each investment.
  4. Don’t manually rebalance positions to retain the initial allocation percentages. Let the winners run until exit criteria is satisfied.
  5. Stay in cash until investment opportunities that align with the investment strategy materialize. Don’t invest in subpar opportunities just for the sake of capital allocation.

The image, “Coins” is copyright © 2012 Jiri Rizek. Jiri is a photographer hailing from the Czech Republic. Used with permission.


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