Like many value investors I have a tendency to use fairly loose and arbitrary position sizing and portfolio management.
I have a concentrated portfolio and tend to base my position sizing on:
-How risky is the investment?
-What is the possible/probable return profile of the investment?
-How much capital do I have left to invest?
-I have no real strict or measured process for selling. I tend to let both winners and losers run and but am quick to sell an investment if I think the long-term outlook has deteriorated. I don't usually sell just because something is 20% overvalued to try and buy it back when its 10% undervalued, etc. In other words I tend not to trade in and out of positions. More buy and hold until the fundamentals change.
The risk of my methodology under a hypothetical scenario based on how I typically invest goes something like this:
I think a stock is a fantastic company and well run and crazily undervalued so I put lets say 40% of my net worth into it (e.g. like Buffett buying into American Express when running the Buffett Partnership). The company produces strong earnings and goes on to triple in share price over the next three years. It now represents 65% of my net worth. Over the next year due to a surprise sudden change (e.g. sudden regulatory change, a competitor brings out a technologically superior new product which takes the majority of market share quickly, etc) the business has permanently deteriorated and the stock price has dropped 70% from its all time high. I decide to sell out due to the deterioration in fundamentals. I have now severely dented the return of my portfolio over the four year period.
Note: the above type scenario has not quite happened to me yet but is definitely possible based on my investment style.
As Buffett points out, a concentrated portfolio can lead to lower risk because you have superior knowledge of what you are investing in and are therefore less likely to be sloppy or make ill-informed or marginal bets. It can also be higher risk if you are not as good a stock picker as you thought yourself to be.
Here is Buffetts view: “The strategy we’ve adopted precludes our following standard diversification dogma. Many pundits would therefore say the strategy must be riskier than that employed by more conventional investors. We disagree. We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it. In stating this opinion, we define risk, using dictionary terms, as ‘the possibility of loss or injury.‘”
Whereas you have Ben Graham for example who had lived through the great depression and was shaped by the experience. He practiced wide diversification (except for rare exceptions like GEICO). Below is a quote from an article
Benjamin Graham insisted that those who followed a value investing strategy structure their portfolio to take advantage of the benefits of diversification. This included diversification of asset class just as much as individual investments. Examining his January 31, 1948 letter to shareholders of the Graham-Newman Corporation, we see that Graham invested:
15.82% of the money in bonds, which were sub-divided into railroads, utilities, real estate, holding companies, and the United States Government,
22.93% of assets into preferred stocks, which were sub-divided into industrials, investment companies, utilities, insurance companies, and holding companies, and
61.25% into common stocks, which were sub-divided into industrials, holding companies, investment companies, railroads, utilities, and insurance companies.
The 61.25% invested in common stocks were spread among 57 different companies, ranging from ship builders to sugar companies in Puerto Rico. This meant that each of Graham’s value investments had a margin of safety all their own, plus the protection of sitting in a larger, extremely diversified portfolio of bonds, preferred stocks, and common stocks. This was consistent with Graham’s belief that the primary goal of value investing was to avoid losing money first, and then to enjoy a satisfactory return on capital thereafter.
I am keen to hear from other value investors how concentrated their portfolios are, how they do position sizing and what are their risk management strategies.