How much should you allocate to a great investment idea? Over 60% of the Large Cap Active Global Equity portfolios in a popular fund database have more than 50 stock holdings. That implies an average investment of around 2% of the portfolio and, say, 3% for the best ideas.
Almost 40% of the database is made up of funds holding more than 80 stocks, which tend to invest even less than 2% in individual investments. This seems quite low, especially for a best idea, which is where John Kelly comes in.
Kelly was a scientist working on noise reduction in long-distance telephone signals at the famous Bell Labs in the 1950s. But it turns out that his algorithm was useful for sizing gambling bets appropriately for a given set of probability-weighted outcomes. The “Kelly criterion” calculates the portion of funds you should place on a bet, with probability-weighted win/loss outcomes, to maximise your long-term return.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Playing with probabilities
We know that investments can be winners (or not) and we can estimate the degree and probability of the win. So the Kelly criterion is useful for investment decision-making as well as Las Vegas.
Let’s say we have a great investment idea with a 75% chance of 30% upside, but a possible 10% downside. Kelly suggests you invest two-thirds of your available funds with an expected return of 20%.
Interestingly, by working the Kelly criterion backwards, we can infer what a portfolio manager thinks of his or her best ideas given the amount invested. For example, a 3% position (roughly 2.5 times the average weight in an 80-stock portfolio) implies that the manager sees the idea as having equal upside and downside but with an upside probability of 51.5%. This does not sound very convincing, and of course the manager is unlikely to agree with that range of outcomes and probabilities. So why not concentrate the portfolio on the few best ideas and forget about the rest? That is what we do. Here are three stocks that we hold with real conviction:
Growth potential in the cloud
Alphabet (Nasdaq: GOOGL) is a well-known internet service provider; the search engine and YouTube form the foundation of the company. Alphabet’s ability to continue to grow its share of advertising revenue is underappreciated, while you might not realise that it has a large cloud- computing business, an area that offers long-term growth.
DaVita (NYSE: DVA), provides dialysis treatments for patients suffering from end-stage renal disease (ESRD). Costs and a rise in client mortality owing to Covid-19 have been a problem, but the market does not appreciate the likely margin improvement as costs normalise. The transfer of patients from Medicare to Medicare Advantage (under the US healthcare system) also offers the potential for margin improvement.
Consider also NVR (NYSE: NVR), a housebuilder in the US with a geographically focused operation (some rivals spread themselves too thin) and a policy of not buying land. This allows it to benefit from economies of scale in construction and minimise the capital employed in the business, improving returns on capital, an important gauge of profitability. It is an unusually shareholder-friendly company.
-
73% of savers plan to rely on partner’s pension in retirementA new survey suggests the majority of people may lack financial independence in retirement, with almost three-quarters set to rely on their partner’s pension
-
How much you need to follow the 25x retirement rule – will you have enough to be financially independent?We explain what the 25x retirement rule is and the amount you would need to be financially independent in retirement.
-
'The rise and fall of Kodak is a lesson for the tech giants'Opinion The long decline of Kodak – a once-dominant company – shows why no business is safe from disruption, says Matthew Lynn
-
8 of the best properties for sale with kitchen gardensThe best properties for sale with kitchen gardens – from a 17th-century timber-framed hall house in Norfolk, to an Arts & Crafts house in West Sussex designed by Charles Voysey with a garden by Gertrude Jekyll
-
Why investors can no longer trust traditional statistical indicatorsOpinion The statistical indicators and data investors have relied on for decades are no longer fit for purpose. It's time to move on, says Helen Thomas
-
Investors rediscover the virtue of value investing over growthGrowth investing, betting on rapidly expanding companies, has proved successful since 2008. But now the other main investment style seems to be coming back into fashion.
-
8 of the best properties for sale with shooting estatesThe best properties for sale with shooting estates – from an estate in a designated Dark Sky area in Ayrshire, Scotland, to a hunting estate in Tuscany with a wild boar, mouflon, deer and hare shoot
-
The most likely outcome of the AI boom is a big fallOpinion Like the dotcom boom of the late 1990s, AI is not paying off – despite huge investments being made in the hope of creating AI-based wealth
-
What we can learn from Britain’s "Dashing Dozen" stocksStocks that consistently outperform the market are clearly doing something right. What can we learn from the UK's top performers and which ones are still buys?
-
The rise of Robin Zeng: China’s billionaire battery kingRobin Zeng, a pioneer in EV batteries, is vying with Li Ka-shing for the title of Hong Kong’s richest person. He is typical of a new kind of tycoon in China
