How Capital Allocation plays role in generating great returns?

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Let’s imagine a scenario. You have developed superb equity research skills over the years so that you can find those companies which will turn into multi baggers. Nowadays you are very good at it. You have identified few companies which is going to be multi-bagger 😀 And you invested in those companies.MoneyMonk's CApital Allocation

But according to conventional wisdom, these micro caps or small caps companies have high beta hence more risky. Hence to mitigate the risk of loosing capital you allocated 5% of your over all portfolio being a smart person. Isn’t it?

Fast forward 1 years down the line, that companies have become 3 bagger and now it has become 3 times of what you invested. You earned decent 18% on your 95% of portfolio and 300% on your 5% portfolio. When you see overall return of your portfolio the returns are only 32% even if you had something which can turn your capital 3x.

I see it as opportunity loss. Your loss is what you have not earned.

So, Capital Allocation is one of the most important part of the whole investment game. Sometimes, more important than Selection of stocks.

To counter this thing I have decided to structure my equity portfolio in following way. Being a young investor I have a luxury to choose something like this.

Future Vision for My Equity Portfolio :

I have made 7-7-7 rule for myself.

  • I aim to hold only 7 companies with in-depth research and high concentration. This will consist of 93% of my portfolio.
  • I will have other 7 companies with 1% allocation each which will help me track them because I am invested. Otherwise its my tendency to loose focus.
  • Further, I will have a space for other 7 companies to look after via some forums or friends. This will help me to reduce my opportunity cost.

You may say this is very risky but I disagree on this. Why?

I was reading Sanjay Bakshi’s BVBF course and I came across this thing,

The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period.

Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a
non-fluctuating asset can be laden with risk.

Source :2011 Annual Report of Berkshire Hathaway

Risk with us relates to several possibilities. One is the risk of permanent capital loss. And the other risk is that there’s just an inadequate return on the kind of capital we put in.

However, it doesn’t relate to volatility at all. For example, our See’sCandy business will lose money-and it depends on when Easter falls -in two quarters each year. So it has this huge volatility of earnings within the year. Yet it’s one of the least risky businesses I know. You can find all kinds of wonderful businesses that have great volatility in results. But that doesn’t make them bad businesses.

Source : Berkshire Hathaway’s AGM for 1993

Hence, According to Buffet and Munger, the risk we shall evaluate is the risk of loosing our capital or not getting good returns on our capital.

The horizon for this kind of evaluation should be of decades and not of quarters. This kind of mental process will help you to differentiate between quarter to quarter volatility vs risk.

By giving only 5% allocation to those wonderful small companies which has potential to grow exponentially, you are risking your capital.

Think about it and share your views in comments.

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2 thoughts on “How Capital Allocation plays role in generating great returns?

  1. Your point about allocating the largest amount to the best capital is a fair one, but I feel that in their desire to emulate Buffett, the mistake investors make is in forgetting their limitations – we simply don’t have the combination of his prodigious ability as a business as well as security analyst. In fact Walter Schloss (a legend in his own right) pointed out – “I also liked the idea of owning a number of stocks. Warren Buffett is happy with owning a few stocks and he is right if he’s Warren but you aren’t, you have to do it the way that’s comfortable for you and I like to sleep nights.”

    To quote Professor Bakshi as well (in this interview – http://www.safalniveshak.com/value-investing-sanjay-bakshi-way-2014-part2/

    “My view is that investors, when they start out, should practice wide diversification and move towards concentrated positions only after about a decade of experience and as they move towards concentrated positions, their propensity to take business risk and management risk will go down but their ability to acquire deep knowledge about a handful of businesses with value creating potential will go up”

    Not trying to discourage you or your approach – concentration definitely works if you are right, but on a risk adjusted basis, having a little more diversification is not a bad idea, if only to protect us from overconfidence and avoid catastrophic blowups during the experience-building years.

    1. Hi Indraneal,

      Thanks for this insightful comment.

      I completely agree with your point. The current investment philosophy is what I think as of now about how should I sail, but it will change over a period of time with the inputs of people like you who is more experienced than me and willing to lend a helping hand.

      I can connect to your point completely that if I will be right in my bets than there will be huge returns(which is very unlikely 😀 {I know}) but wide diversification will help me to stay in the game and do more.

      Thanks again. Seen you blog and added to my reader. Will read forward.

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