This question is likely one of those where you will receive many different answers, depending on who you ask. Advocates of big positions are likely to tell you that without decent individual positions in a concentrated portfolio, you won’t achieve any meaningful returns. Practitioners of many small positions, on the contrary, will warn you about the risks of putting all your eggs in one basket. So, who’s right, what is definitely wrong, and what to apply?

Summary and key takeaways from today’s Weekly
– Both strategies have their raison d’être – however, it depends on the type of investor you are. At the end of the day, you must be able to sleep well at night.
– Concentrated portfolios only make sense, if you know what you are doing and have high conviction.
– Broadly diversified portfolios can also make sense. But very small positions of 1% or 2% should be in stocks that have very high optionality and not companies where way above-average growth is nonexistent.

Reaching a clear agreement or recommendation among the majority of people is almost impossible regarding this question.

That’s for sure.

Certainly you’ve already been in this situation yourself: “How much of an individual stock should I buy relative to my whole portfolio?”. This critical question refers to proper position sizing of an individual’s equity portfolio.

If you buy big, you can win big – but you can also lose big. If you buy small, your gains will be small, too. So will be your losses. Right? The pros and cons of both approaches in theory are quickly understood, but there is no clear answer to this question as to which to apply generally.

One of the reasons is that not every investor has the same risk profile and emotional stability. Another is that time horizons of investments differ. But also, return expectations do not have to be the same. And then there are also stocks that have an “own life”, ignoring broader market movements.

While more defensive investors are fine with a yearly return of 6–7%, as long as they do not suffer big drawdowns, the higher potential reward certainly comes with a more offensive, yet also more volatile setup.

One typical slogan is also that without a decent sized position, you won’t have any “life-changing” investment. This likely also depends on one’s understanding and definition of “life-changing”, as a big loss can also be life-changing, however, certainly not in the same way.

But surely, it is clear that if you pick a big winner, it can cover nearly all your other losses and dramatically pull up your average portfolio return, provided you hold this one big ticket and don’t sell it prematurely due to being afraid of losing it all again.

You know, the Apple’s (ISIN: US0378331005, Ticker: AAPL) or Tesla’s (ISIN: US88160R1014, Ticker: TSLA) that everyone dreams of discovering early.

While you won’t read in this latest Weekly about “the best approach” in this regard, as every investor is different and I am convinced that there is no one size fits all strategy for everybody, there are some things that everyone should know and be aware of.

Maybe this helps you to improve your own position sizing.

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The differences of both approaches

I’d like to start with the approach of “concentrated bets”, as they are also called.

However, “bets” should not be taken by its true meaning, as it is insane to speculate with very high positions on binary outcomes. This is certainly not what it is about.

In most cases, this approach is followed by experienced investors and often professionals that take time to do serious and in-depth analysis before they buy any stock. This way, you can lower your risks dramatically, if you separate the wheat from the chaff, i.e. all those stocks that you don’t feel comfortable with.

It can be for different reasons. The three most common likely are:

• not understanding the business model enough
• a good business, but too high a price (not the nominal stock price, but the valuation of the whole business)
• low-quality business

And yes, of course, even a high-quality business can be too expensive and thus result in a poor stock investment. Even despite the underlying business growing strongly! If everything and beyond is already priced into the stock, there is no upside left. The market will correct this anomaly sooner or later.

You should always keep this in mind!

Just imagine you bought a stock like Microsoft (ISIN: US5949181045, Ticker: MSFT) at the height of the Dotcom-bubble at a PE ratio of 100x. This by itself is already difficult to buy exactly at the top. Even 50x would have been insane.

And guess what happened afterwards?

You just needed to wait a paltry nearly 17 years to break-even again.

I know there have been dividends paid in between and it is likely that an investor would have averaged down here and there to shorten this period.

But don’t tell me that this does not affect you psychologically!

In these 17 years, sales grew from 23 bn. USD to 56 bn. USD. Free cash flow increased from 13 bn. USD to 32 bn. USD.

Figures per end of fiscal 2000 and 2017 – see here and here.

What I want to show you is that even if you have a strongly growing underlying business, the stock nonetheless can be a disastrous, unnerving investment!

This is why fundamental analysis and valuations are so important.

You certainly have heard of the “margin of safety” concept that famous investors like Benjamin Graham, Warren Buffett, Charlie Munger or Seth Clarman have been advocating. In a nutshell, they want to make sure that they leave enough room for potential errors that are impossible to circumvent completely.

They all define market risk sort of as an ignorant form of investing, i.e. not knowing what you’re doing and not applying any risk assessment. However, don’t confuse “risk” with volatility, as this type of professionals doesn’t view volatility as risk.

It is about understanding the business enough to eliminate as much downside risk as possible.

Critical points are predictability and thus safety of expected free cash flows in comparison to the price you pay for a stock. And nothing else. Temporary market movements are irrelevant.

Everyone is wrong from time to time.

But with a high enough margin of safety, i.e. a low enough price (valuation) compared to your expectations, you are likely going to do a lot better than by buying assets that are priced for perfection and in everyone’s favor already.

Then – and only then! – it can make sense to have a concentrated portfolio.

You need full conviction and be aware of what you are doing. Your portfolio performance can still and likely will be volatile. You won’t eliminate that. But when you are convinced, you do sleep better. It does not make sense to have a highly concentrated portfolio and at the same time look nervously at stock prices like a day-trader (though good traders also have a proper risk management!).

Quite the opposite is the concept of broad diversified portfolios.

It is hard to draw a line between a concentrated and a diversified-enough composition. However, one can argue that a broader diversification effort starts at around 15–20 individual positions. Others argue that you need at least 30 or even 50 single stocks.

You can do the math yourself:

• 20 positions means 5% on average per position or there will always be individual stock with more than 5% as others will fall below this threshold.
• With 50 stocks, the average is 2% per position.

In the end, it depends on with which setup you feel best.

What is clear is that potential losses don’t cause that much damage to your overall portfolio if it only is a small position. For example, a loss of 50% by a 1% position does not make any difference at the end of the day. However, a 20% position that drops by 25% after bad results will cause an immediate 5% damage – this one position alone!

But you also should keep in mind that besides likely having a lower overall portfolio performance with too many stock positions as winners get diluted, a higher amount also increases the clutter potential, i.e. it becomes harder and more time consuming to monitor each and every single position.

This can get complicated, if you’re spending much time on fundamental analysis.

But on the other hand, it can be a good approach if you only buy household names, let’s say 30 blue chip stocks from different sectors and let them do the work. You only check from time to time how the entire portfolio developed, without spending too much time on single positions.

The typical “buy and forget” approach (without having to pray).

This way, you will approach a market return – the more positions you own, the closer your overall performance will be to the market averages – which can be a good thing, depending on what your expectations are. You could also rebalance from time to time or simply cut the losers only and let the flowers (your top performers) run.

This is the theory behind both concepts.

Now, let’s have a look at the core question: Are small positions useless or when and how could it make sense to implement this strategy?

(When) is it worth it to buy small positions?

First, the logical answer to this question: It can only make sense to initiate ultra-low starting positions in a stock in the case that it has the potential to achieve above average returns.

With this, I don’t mean 8% p.a. instead of 6%.

You would rather think of potential multi-bagger stocks where the underlying business grows way above average or a massive share repurchase program is under way, like among those that my Premium PLUS Members receive exclusive research reports about (see here for more information).

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These are the tickets that have the potential to be really life-changing and at the same time likely will not cause any meaningful damage to your overall portfolio due to small incremental sizes of let’s say 1–2%.

But how life-changing can one such small-sized position be, in case it really becomes a multi-bagger of the magnitude of a once-in-a-lifetime stock pick? Let’s find out and look at several calculations I did.

The basic assumptions are:

• Investment horizon: 20 years
• 100.000 EUR stock portfolio
• 1%, i.e. 1.000 EUR, gets invested into a multi-bagger with above-average growth rates
• the remaining 99% of the portfolio achieve market average returns of 6% p.a.

I created four scenarios, the only difference being the growth rate of the multi-bagger stock and always starting at 1%.

Here’s what happens if you apply the above to a 10% grower:

The result is, after 20 years of setup and doing nothing, your 10% grower will have multiplied by 6x. However, due to your portfolio having tripled at the same time, the initially small sized position does not make a meaningful difference as its end-weight would be only 2%.

How does it look with a stock that grows with 15% on average?

It slowly gets better.

The initially small 1%-position grows into an overall 4.5%. Okay, but still not life-changing, despite it having gone up by 14x.

Now, a 20% grower:

Now, it really starts to get interesting.

An additional nearly 10% boost to the overall average portfolio, as the grower went up by close to 32x.

And the last example, the most extreme, however, not unrealistic: A 25% p.a. grower:

Now, it starts to really make fun.

“Only” 5% in more yearly performance – 25% p.a. instead of 20% – brings double the result, at least regarding the position of the grower.

The stock that in this scenario went up 69x makes for an overall nearly 19% of the entire portfolio.

I know these are pretty simplified examples. But are they realistic and applicable?

Of course they are.

First, you should not think of the 99% portfolio of only consisting of slowly growing stocks. It can include many “bets” that have the potential to go up by 20x, 50x or more. But they achieve on average 6% p.a. together with all the other stocks, as most of such growth stories do not materialize.

And then, just the one hit brings you the extra boost.

Take for example one of the success stories of the last 20 years: Apple.

You see, over the last 20 years, the stock went up from 0.38 USD to 193.99 USD.

This is a plus of 50,950 % or a near-510 bagger. I think, now you see that my examples have been rather on the conservative side when we are talking about really great stocks. And don’t forget that Apple’s dividends are missing in this calculation.

The average yearly return just of the stock without dividends is 36.6% – per year. So you see that I did not even use the most extreme examples above.

The bottom line is: if you are using this portfolio strategy of putting in several 1% initial positions, then make sure that they have a high enough “optionality”.

It does not make sense from a practical perspective to put in today’s Apple stock with a 1% weight, as it is unlikely – next to impossible – that it continues to compound at 36% annually.

But if you have the next potential Apple on your watchlist – or the next Monster Beverage (ISIN: US61174X1090, Ticker: MNST) that I wrote about in my Weekly here, then it can make for a good compromise between defensive enough to avoid huge damage in case of a disappointment and still having enough in the tank to meaningfully contribute to the overall portfolio.

Of course, you could also think about starting with 2%, instead of 1%.

This should be still defensive enough, but already offering double the potential.

Conclusion

Both strategies have their raison d’être – however, it depends on the type of investor you are. At the end of the day, you must be able to sleep well at night.

Concentrated portfolios only make sense, if you know what you are doing and have high conviction.

Broadly diversified portfolios can also make sense. But very small positions of 1% or 2% should be in stocks that have very high optionality and not companies where way above-average growth is nonexistent.

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