Hi everyone. I am a former Hedge Fund trader who now invests his own capital. I have spent a lot of time trying to work out an investment process to value companies. The first and most crucial issue to me is how much capital do I allocate to shares. I have decided to use the following portfolio allocation rules.
I must be risk averse with my family’s capital
I must be risk averse with my family's capital because if I doubled our capital the impact on my family’s life would not be that significant, whereas, if this capital halved, the impact would be enormous. Warren Buffet explained how foolish it is to take unnecessary risks when he said:
He went on to use the excellent analogy:“It is foolish to risk something that is important to you for something that is unimportant to you. I do not care if the odds you succeed are 99 to 1 or a 1000 to 1”.
How I will allocate my family’s capital“If you hand me a gun with million chambers with one bullet in a chamber and put it up to my temple and I'm paid to pull the trigger, it doesn't matter how much I would be paid. I would not pull the trigger - yet people do this financially all the time without thinking.”
I will simply invest my family's capital in assets where I think the probable return justifies the risk. I will not decide where to invest my family's capital based on the recommendations of some asset allocation model or portfolio optimisation theory.
I will focus on absolute not relative performance
What I want to do is preserve my family’s capital and get a good long-term return on this capital relative to the risk. Whether the short-term returns I get on this capital are much lower than the returns from investing it in ‘the market’ (for example, a passive index fund) is irrelevant.
I must not invest more than 10% of my family's capital in a separate industry
I have a 10% limit for investing in an industry because of the risk that my family could lose most of that capital. This could occur because some unforeseen event (such as the invention of the internet) makes the industry far less viable and, thus, the intrinsic value of businesses in the industry falls dramatically.
I must not invest more than 5% of my family’s capital in an individual business
I have a 5% limit for investing in an individual business because of the risk that my family could lose most or all of this capital. This could occur because I paid far too much for the business (I seriously overestimated its intrinsic value), or that bad luck significantly reduces the business’s intrinsic value.
Much more to come...