How to Allocate Capital to Your Investment Ideas
If you have been following my program of learning to invest, you have thus far learned how to value a business, learned how to generate plenty of investment ideas, learned how to set up an idea management system to push your ideas along, and now have a list of approved, vetted, researched stock ideas and are ready to buy them for your portfolio.
This article is the first in a series of articles about portfolio management and it will give you some guidelines for constructing a portfolio appropriate for your specific situation.
Use opportunity cost to allocate capital
The first key concept to understand is that of opportunity cost. For an introduction to opportunity cost, you can read an article I wrote about opportunity cost or listen to the podcast episode on opportunity cost.
In a nutshell, you should always have:
- dry powder (cash) laying around
- should spread out your buying of any one position over at least a year, and
- have multiple ideas to choose from at any one point in time
These three key ingredients comprise opportunity cost. If you start out as a new investor with a full understanding of opportunity cost, you will be much further ahead than most all other investors.
Develop a working knowledge of major demographic and economic trends
A second key component of portfolio management is to have a working understanding of major demographic and economic trends. Some of these trends include:
- Baby boomers retiring
- Millenials moving out of the parental home
- Retail landscape changing, especially malls
- Software eating the world and artificial intelligence eating software
- Rising or falling interest rates
The point here is to understand how these trends can impact the businesses you are investing in. You don't have to become an expert on the topics, just need a working knowledge.
Combining opportunity cost and understanding of major trends can lead to portfolio decisions that result in serious out-performance of overall markets. Warren Buffett is the master of demographic investing. Many of his investments are in consumer-facing business such as insurance, soda, fast food and furniture. Do you think he is ignorant of major demographic trends?
Favor investment ideas with the largest margin of safety
Your margin of safety is the difference between what you determined the business is worth per share, and the price you are paying per share. In making portfolio decisions, you should be focused on the margin of safety you have in each idea and be buying the ideas with the largest margin of safety first.
One way to think about this is to ensure that your portfolio ALWAYS consists of your best ideas with the highest margin of safety.
When you set up your buying programs, allocate your capital to these best ideas with the largest margin of safety first. As the price changes, you may need to shift your buying program around to ensure you are still buying the best ideas with the largest margin of safety.
You should never be fully invested and you should consider cash as a position
As I pointed out earlier, running your portfolio based on opportunity cost requires you to have cash as a position. Here are the rules I suggest you set regarding cash.
- You should have 30% of your portfolio in cash in normal markets
- If the market corrects 10% from its most recent peak, you should invest 1/3 of the cash (33% of the cash position, or 10% of the total account. For example, if you portfolio size was $100,000, cash would start out as $30,000 (30%). If the market corrects 10%, you would invest 1/3 of the cash ($30,000 / 3 = $10,000).
- If the market corrects another 10% so that it is down 20% from its most recent peak, you invest another 1/3 of the cash (another $10k)
- If the market corrects another 10% so that it is down 30%, put the rest of the cash into the market.
When I say "put the cash into the market", what I mean is that you can add the additional cash into your buying program, not just dump it all in at once.
Now the question is, now that I am fully invested, when do I go back to a 30% cash position? The basic answer is to follow your sell disciplines which will help you answer the question position by position.
You can also set a market-based sell discipline that you will exit positions that are at or above your estimate of intrinsic value when the market has come back to it's most recent high. If the market had fallen 30% and returned to its most recent high, you should have substantial profits and a fair number of positions that have reached intrinsic value.
Your capital allocation activity should include breaking your portfolio into different investment strategies
When you set up a capital allocation plan, you should give consideration to breaking your portfolio up into blocks with different strategies. As an example, when he was managing the Buffett partnerships, Warren Buffett had the portfolio broken into three categories: generals, work-outs, and controls.
The strategies you choose need to be right for you and your investment goals. The point I want to get across is to have specific groupings and percentages in mind when you create your capital allocation strategy.
One other thing to keep in mind is that the market may not offer you something worth buying at a price worth paying for a long period of time. This means that your percentage allocation to each strategy needs to be somewhat flexible. Sometimes the market will give you lots of "general" ideas and no workouts. Opportunity cost means that you can't just ignore what the market is offering up if it's a good value.
The topic of capital is a big one and you should consider this article as an overview on the topic. Learning capital allocation is really a life-long process and you will learn a lot of lessons along the way. For now, be sure the incorporate in your capital allocation strategy:
- Opportunity Cost
- Major demographic and economic trends
- Margin of safety
- Various investment strategies / types
Be sure to read all the other articles in this series on portfolio management