Portfolio Sizing - Prof Bakshi's pointers on having a good process

I was going through my notes of a discussion I had with Prof Bakshi (you can reach the goldmine of investment writing here) on portfolio sizing - a topic which I think has been very less explored in financial writing and books.

Here are some of the pointers he had said. Re-reading them again reinforces the right way to think about this topic.

1. Learn what NOT to do. For example, Kelly Formula, which is widely used in betting systems is not a reliable mechanism in investing. Because you cannot predict definitive probabilities in the market, and hence cannot know the computable odds of winning or losing.

2. It is reasonable to start with similar weights, but one can think of allocating higher to higher conviction bets. 

3. Portfolio sizing depends on investment style. If you follow Munger, Phil Fisher then a concentrated approach is possible. Read Phil Fisher's chapter on when to sell

4. Regret analysis - understand how much you will regret if the worst case scenario plays out in the stock with high allocation. Do you have the wherewithal to withstand a major catastrophe in the stock? Determine your sleeping level.

5. Think across disciplines (horizontally) on what can be the risks of stocks in your portfolio. There may be a portfolio level concentration of a single factor which if plays out can mean a lot of problems. e.g. if you have stocks in different sectors but with a common factor of market/ factory in Maharashtra and the state has a major earthquake. Diversify thoughtfully.

6. Read "Principles of Underwriting" by Warren Buffett which is for insurance underwriting but is equally useful to think about portfolio sizing.

 

The 3 points that Buffett has wrtitten as principles of underwriting in his 2001 investor letter
1) They accept only those risks that they are able to properly evaluate (staying within their circle of competence) and that, after they have evaluated all relevant factors including remote loss scenarios, carry the expectancy of profit. These insurers ignore market-share considerations and are sanguine about losing business to competitors that are offering foolish prices or policy conditions.

2) They limit the business they accept in a manner that guarantees they will suffer no aggregation of losses from a single event or from related events that will threaten their solvency. They ceaselessly search for possible correlation among seemingly-unrelated risks.

3) They avoid business involving moral risk: No matter what the rate, trying to write good contracts with bad people doesn't work. While most policyholders and clients are honorable and ethical, doing business with the few exceptions is usually expensive, sometimes extraordinarily so.

My take from an investment perspective on these 3 points are:

Point 1 - First consideration is risk management. It is alright to let go of phenomenal returns (in a roaring bull market) by keeping away from buying stocks just because others are doing so.

Point 2 - Prof Bakshi's point 5. Diversify so that one event does not have cascading and catastrophic impact on your portfolio.

Point 3 - Don't bet on companies with bad managements. It does not pay in the long run.