Capital allocation: How much to buy?
The puzzle of how much of a stock to buy becomes easier once you realise there's no need to get every portfolio management decision right.
Last week, in Asset allocation: Taking the first step, we looked at the broad topic of asset allocation in portfolio management. The idea was to make sure you're considering all the asset classes a well-diversified portfolio might contain.
This week we're narrowing the portfolio management topic down to your share portfolio alone. If you've ever wondered how much capital you should devote to each stock, this is for you. You might sometimes hear this called ‘position sizing' although, as that has the whiff of the day-trader about it, we'll go with ‘capital allocation'.
Capital allocation is an important skill. Too many people focus only on what stocks to buy. Correspondingly, they pay too little attention to how much cash each stock deserves.
How much you allocate is a function of two (related) factors – risk and value. Let's deal with risk first.
Higher risk, lower weighting
The principle is simple. Higher risk stocks deserve less of your capital (and vice versa). No matter how promising its technology, a barely profitable biotech company will always be riskier than a large, defensive business such as Woolworths (ASX: WOW).
Before buying you should analyse how risky the company is – including how those risks might correlate with others in your portfolio – then allocate capital accordingly. The context of your portfolio is important; if you already have a 30% weighting to banks – and you probably shouldn't – adding another bank with a weighting of 5% is unwise.
Intelligent Investor can help here because, as well as our recommendations and price guides, we provide risk ratings on stocks and guidelines for portfolio weightings. For example, we've recommended a 2% ‘maximum portfolio weighting' for Somnomed (ASX: SOM) but an 8% weighting for Woolworths. Reverse those weightings – for example – and you are likely to be taking too much risk.
Capital allocation is also a function of value. Again the principle is simple – stocks that are better value deserve more of your capital (and vice versa). If you're unsure if a stock offers excellent value – and it is usually uncertain – then you should start off with a lower portfolio weighting than the maximum.
Take the example of Flight Centre (ASX: FLT), which we upgraded to Buy in November last year. Our recommended portfolio weighting is 6%, but we recommended starting off with a half-weighting of 3%. The idea was to ‘dip a toe in the water', as Flight Centre's share price has traditionally been volatile and it was also possible that profitability might deteriorate. Had the value equation tipped more in our favour, then we would have recommended adding more capital (as it turns out, the share price has jumped 21%).
Take your time
There's a simple way to make better capital allocation decisions – use time to your advantage. Inexperienced investors sometimes think investing is about getting each decision right, but that's neither true nor possible. Rather you should try to get the average decision right over time.
When applied to capital allocation, the idea here is to buy multiple parcels of stock rather than jump to a full weighting immediately. Returning to the example of Flight Centre, if you followed our recommendation you will currently own a weighting of around 3–4% (given the stock's rise). If the stock becomes undervalued again, that's when you'll buy your additional stake.
It's sometimes said that value investors buy too early. That might be true of the first parcel, but it's not necessarily true of the second (or third). By ensuring you keep some capital in reserve, you can take advantage of lower prices if and when they occur.
To help you analyse your portfolio weightings, it's important to record everything in a portfolio management tool. InvestSMART's Portfolio Manager, for example, tells you the weighting for every stock in your portfolio (Intelligent Investor research and ASX announcements are also integrated, so it's a one-stop shop).
Once you know your portfolio weighting, you'll be much better placed to decide which holdings might need topping up over time – or which ones might need a trim. Just make sure you only buy underpriced stocks (see Building and Managing your Portfolio) rather than trying to meet pre-determined weightings.
Before buying your next stock, put these principles into action. Allocating capital correctly – or otherwise – can make a surprising difference to your portfolio performance. Buying underpriced stocks in parcels over time is a sensible way to manage your portfolio.
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